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Top AccounTing issues for 2017 CPE CoursE

Bonus cpe course! Earn CPE Credit and stay on top of key Accounting issues. Go to CCHGroup.com/PrintCPE

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Top Accounting Issuesfor 2017 ⏐ CPE Course

Steven C. Fustolo, CPA and Contributing Authors

Contributors

Contributing Editor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Kelen Camehl, CPA

Technical Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sharon R. Brooks, CPA

Lorraine Zecca, CPA

Production Coordinator . . . . . . . . . . . . . . Mariela de la Torre; Jennifer Schencker;

Vignesh Lakshmikanthan

Production . . . . . . . . . . . . . . . . . . . . . . . . . . . Lynn J. Brown; Anbarasu Anbumani

This publication is designed to provide accurate and authoritative information inregard to the subject matter covered. It is sold with the understanding that thepublisher is not engaged in rendering legal, accounting, or other professionalservice. If legal advice or other expert assistance is required, the services of acompetent professional person should be sought.

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IntroductionTop Accounting Issues for 2017 CPE Course helps CPAs stay abreast of the most significantnew accounting standards and important projects. It does so by identifying the events of thepast year that have developed into hot issues and reviewing the opportunities and pitfallspresented by these changes. The topics reviewed in this course were selected because oftheir impact on financial reporting and because of the role they play in understanding theaccounting landscape in the year ahead.

Module 1 of this course reviews ongoing issues.

Chapter 1 discusses the changes to lease accounting that are the result of ASU 2016-02and the effects those changes may have.

Chapter 2 provides an overview of the accounting and reporting amendments withrespect to Accounting Standards Update 2015-11 released by the FASB in July 2015. ThisASU is part of the FASB’s Simplification Initiative and applies to entities that measure theirinventory using either the first-in first-out (FIFO) or average cost methods. The ASU did notmake changes to inventories measured using either last-in first-out (LIFO) or the retailinventory method.

Chapter 3 provides an overview of the accounting and reporting requirements withrespect to deferred income taxes and net operating losses. This includes a discussion ofvaluation accounts, future income considerations, as well as differences between varioustypes of carryforwards. This chapter also discusses the key requirements codified withinASC 740 from FIN 48 and certain changes prescribed by ASU 2015-17. Finally, the chapterconcludes with a discussion related to corporate tax rates across different countries in theworld.

Module 2 of this course reviews financial statement reporting.

Chapter 4 examines studies and recommendations that will hopefully lead to a compre-hensive business reporting model that is valuable from the investor’s perspective.

Chapter 5 provides an overview of the consolidation guidance prescribed within ASC810 along with the significant amendments to the guidance from ASU 2015-02. This includesan in-depth analysis of five specific areas where ASU 2015-02 made specific amendments tothe consolidations guidance along with illustrative examples.

Module 3 of this course reviews other current developments.

Chapter 6 provides an overview of the accounting and reporting requirements withrespect to costs incurred related to terrorism and natural disasters. This includes a discus-sion of the disclosure requirements, the treatment of insurance recoveries, as well as therelated income statement presentation and certain tax consequences.

Chapter 7 reviews some recent ASUs related to going concern assessment by manage-ment, debt issuance costs, internal-use software, and identifiable intangible assets in a privatecompany business combination.

Chapter 8 provides an overview of information and statistics that suggest that companydefined benefit pension plans are on the decline. This includes an analysis of the significantunfunded liabilities with respect to various pension plans, both from the governmental andnongovernmental standpoint. This chapter also discusses how pension plans can influencetheir total pension liability based on changes in assumptions used in the pension liabilitycalculation.

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Study Questions. Throughout the course you will find Study Questions to help you testyour knowledge, and comments that are vital to understanding a particular strategy or idea.Answers to the Study Questions with feedback on both correct and incorrect responses areprovided in a special section beginning at ¶10,100.

Index. To assist you in your later reference and research, a detailed topical index has beenincluded for this course.

Final Exam. This course is divided into three Modules. Take your time and review allcourse Modules. When you feel confident that you thoroughly understand the material, turnto the Final Exam. Complete one, or all, Module Final Exams for continuing professionaleducation credit.

Go to CCHGroup.com/PrintCPE to complete your Final Exam online for immediateresults and no Express Grading Fee. Your Training History provides convenient storage foryour CPE course Certificates. Further information is provided in the CPE Final Examinstructions at ¶10,200.

August 2016

PLEDGE TO QUALITY

Thank you for choosing this CCH® Learning Solutions product. We will continue to producehigh quality products that challenge your intellect and give you the best option for yourContinuing Education requirements. Should you have a concern about this or any otherWolters Kluwer product, please call our Customer Service Department at 1-800-248-3248.

COURSE OBJECTIVES

This course provides an overview of important accounting developments. At the completionof this course, the reader will be able to:

• Identify the changes that will be made under the new lease standard

• Recognize how existing leases will be handled when the new statement becomeseffective

• Identify the measurement basis used to measure FIFO and LIFO inventories underASU 2015-11

• Recognize how to account for a recovery of an inventory write-down in subsequentperiods

• Identify the GAAP rules for measuring and recording a deferred tax asset and relatedvaluation account

• Recognize and differentiate between the various types of carryforwards

• Identify key requirements codified within ASC 740 from FASB Interpretation No. 48

• Recognize the key changes prescribed by ASU 2015-17

• Identify some of the 12 recommended principles for the Comprehensive BusinessReporting Model

• Recognize some of the key ratios used to analyze working capital

• Identify some of the symptoms of inefficiently managed working capital

• Recognize a key aspect of a VIE

• Recall situations in which use of combined statements is useful and not useful


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• Recognize a key change to the consolidation model made by ASU 2015-02 with respectto a general partner of a limited partnership

• Identify some of the rights a noncontrolling limited partner might have in a limitedpartnership

• Identify the accounting and disclosure requirements related to certain risks anduncertainties and those related to terrorism and natural disasters

• Recognize how certain insurance recoveries should be accounted for in an entity’sfinancial statements

• Explain changes made to going concern assessment by ASU 2014-15

• Identify one of the criteria that must be met to treat a hosting arrangement as internal-use software

• Identify how to account for intangible assets under ASU 2014-18’s accountingalternative

• Recognize statistics related to unfunded liabilities prevalent across defined pensionplans

• Recognize key requirements prescribed by GASB Statement No. 68

• Differentiate between the various color zones used to assess pension plan health

One complimentary copy of this course is provided with certain copies of Wolters Kluwerpublications. Additional copies of this course may be downloaded from CCHGroup.com/PrintCPE or ordered by calling 1-800-248-3248 (ask for product 10024493-0004).



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Contents

MODULE 1: ONGOING ISSUES1 Changes to Lease Accounting

Welcome . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶101Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶102Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶103Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶104The SEC Pushes Toward Changes in Lease Accounting . . . . . . . ¶105FASB-IASB Lease Project . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶106Basic Concepts of ASU 2016-02 Leases (Topic 842) . . . . . . . . . . ¶107Lessee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶108Short-Term Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶109Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶110Effective Date and Transition . . . . . . . . . . . . . . . . . . . . . . . . . . ¶111Impact of Changes to Lease Accounting . . . . . . . . . . . . . . . . . . . ¶112

2 Simplifying Inventory MeasurementWelcome . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶201Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶202Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶203Changes Resulting from the ASU . . . . . . . . . . . . . . . . . . . . . . . ¶204Subsequent Measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶205Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶206Implementation of ASU 2015-11 . . . . . . . . . . . . . . . . . . . . . . . . ¶207

3 Deferred Income Taxes and Net Operating LossesWelcome . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶301Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶302ASC 740 – The Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶303Deferred Income Tax Assets From NOLS . . . . . . . . . . . . . . . . . . ¶304Balance Sheet Presentation . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶305Future Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶306

MODULE 2: FINANCIAL STATEMENT REPORTING4 Financial Performance Reporting by Business Enterprises

Welcome . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶401Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶402Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶403Financial Community’s View of FinancialReporting and Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶404FASB Starts up Financial Performance Reporting Project . . . . . . ¶405The Focus on Cash Flow, Working Capital and Other FinancialMeasurements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶406Working Capital Management . . . . . . . . . . . . . . . . . . . . . . . . . . ¶407

5 Consolidation AnalysisWelcome . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶501Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶502

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Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶503Overview of Existing GAAP Rules for Investments andConsolidations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶504Consolidations and Combined Statements . . . . . . . . . . . . . . . . . ¶505ASU 2015-02 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶506ASU 2015-02 Amendments . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶507Consolidation Guidance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶508Key Changes Made by ASU 2015-02 . . . . . . . . . . . . . . . . . . . . . ¶509Change 1: Limited Partnership Interests and Similar Legal Entities ¶510Change 2: Fees Paid to Decision Makers or Service Provider as aVariable Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶511Change 3: The Effect of Fee Arrangements on the PrimaryBeneficiary Determination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶512Change 4: The Effect of Related Parties on the Primary BeneficiaryDetermination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶513Change 5: Certain Investment Funds . . . . . . . . . . . . . . . . . . . . . ¶514ASU 2015-02 Transitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶515

MODULE 3: OTHER CURRENT DEVELOPMENTS6 GAAP for Terrorism and Natural Disasters

Welcome . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶601Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶602Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶603Disclosure Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶604Lossess from Terrorism or Acts of God . . . . . . . . . . . . . . . . . . . . ¶605Insurance Recoveries from Terrorist Attacks . . . . . . . . . . . . . . . . ¶606Involuntary Conversions Under GAAP . . . . . . . . . . . . . . . . . . . . ¶607Business Interruption Insurance Recoveries . . . . . . . . . . . . . . . . ¶608

7 Recent ASUs: Going Concern, Debt Issuance Costs, and IntangiblesWelcome . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶701Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶702Recently Issued ASUs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶703Going Concern Assessment by Management- ASU 2014-15 . . . . ¶704Fees Paid in a Cloud Computing Arrangement-ASU 2015-05 . . . . ¶705Simplifying the Presentation of Debt Issuance Costs -ASU 2015-03 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶706Accounting for Identifiable Intangible Assets in a BusinessCombination – ASU 2014-18 . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶707

8 The Gradual Demise of Company Pension PlansWelcome . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶801Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶802Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶803GAAP Rules for Defined Benefit Plans - ASC 715 . . . . . . . . . . . . ¶804Single-Employer Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶805Underfunded Multi-Employer Pension Plans andthe Loaded Pistol . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶806The Pension Plan Assumptions Manipulation Game . . . . . . . . . . ¶807State Pension Plans- An Accident Waiting to Happen . . . . . . . . . ¶808

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Can Companies Afford to Offer Adequate Pensions and OtherBenefits in the Future? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶809Who Pays for the Funding Shortfalls in Pension Plans? . . . . . . . . ¶810Trends in Pensions and Compensation . . . . . . . . . . . . . . . . . . . ¶811New Defined Benefit Plan Mortality Tables . . . . . . . . . . . . . . . . . ¶812U.S. Pension Plans are Moving from Equities to Bonds . . . . . . . . ¶813

Answers to Study Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,100Module 1—Chapter 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,101Module 1—Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,102Module 1—Chapter 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,103Module 2—Chapter 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,104Module 2—Chapter 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,105Module 3—Chapter 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,106Module 3—Chapter 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,107Module 3—Chapter 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,108

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page191

Final Exam Instructions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,200Final Exam Questions: Module 1 . . . . . . . . . . . . . . . . . . . . . . . . ¶10,301Final Exam Questions: Module 2 . . . . . . . . . . . . . . . . . . . . . . . . ¶10,302Final Exam Questions: Module 3 . . . . . . . . . . . . . . . . . . . . . . . . ¶10,303

Answer Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,400Module 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,401Module 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,402Module 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,403

Evaluation Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ¶10,500

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MODULE 1: ONGOING ISSUES—CHAPTER1: Changes to Lease Accounting¶101 WELCOMEThis chapter discusses the changes to lease accounting that are the result of ASU2016-02 and the effects those changes may have.

¶102 LEARNING OBJECTIVES

Upon completion of this chapter, you will be able to:

• Identify the changes that will be made under the new lease standard

• Recall how lessees will account for leases under the new standard

• Identify the items that are considered part of the lease payment under the newstandard

• Recall how the lessee calculates the liability for a lease under the new standard

• Recognize how existing leases will be handled when the new statement be-comes effective

• Determine the effect the new standard may have on future lease terms

• Recognize how the new standard may affect book/tax differences, EBITA, anddebt-equity ratios

¶103 INTRODUCTIONThe FASB approved a final statement on lease accounting that was issued in February2016. The statement results in the culmination of a decade’s work to dramaticallytransform how companies account for leases.

In particular, most leases will be capitalized resulting in billions of dollars of assetsand liabilities being recorded on company balance sheets.

Although the lease accounting project has gone through numerous changes, thefundamental concept that leases be capitalized did not change in the final document.

¶104 BACKGROUNDUnder current GAAP, ASC 840, Leases, divides leases into two categories: operating andcapital leases. Capital leases are capitalized while operating leases are not. In order for alease to qualify as a capital lease, one of four criteria must be met:

• The present value of the minimum lease payments must equal or exceed 90percent or more of the fair value of the asset.

• The lease term must be at least 75 percent of the remaining useful life of theleased asset.

• There is a bargain purchase at the end of the lease.

• There is a transfer of ownership.

In practice, it has been common for lessees to structure leases to ensure they do notqualify as capital leases, thereby removing both the leased asset and obligation from thelessee’s balance sheet. This approach has been typically used by restaurants, retailers,and other multiple-store facilities.

¶104

2 TOP ACCOUNTING ISSUES FOR 2017 CPE COURSE

EXAMPLE: Lease 1: The present value of minimum lease payments is 89percent of the fair value of the asset and the lease term is 74 percent of theremaining useful life of the asset.

Lease 2: The present value of minimum lease payments is 90 percent of thefair value of the asset or the lease term is 75 percent of the remaining useful life ofthe asset.

Lease 1 is an operating lease not capitalized, while Lease 2 is a capital leaseunder which both the asset and lease obligation are capitalized.

¶105 THE SEC PUSHES TOWARD CHANGES IN LEASEACCOUNTINGIn its report entitled “Report and Recommendations Pursuant to Section 401(c) of theSarbanes-Oxley Act of 2002 On Arrangements with Off-Balance-Sheet Implications,Special Purpose Entities, and Transparency of Filings by Issuer,� the SEC targeted leaseaccounting as one of the areas that resulted in significant liabilities being off-balance-sheet.

According to the SEC Report that focused on U.S. public companies and a U.S.Chamber of Commerce Report:

• Sixty-three percent of companies record operating leases while 22 percentrecord capital leases.

• U.S. companies have approximately $1.5 trillion in operating lease obligationsthat are off-balance-sheet.

• European companies have a total of approximately $928 billion in off-balance-sheet operating lease obligations.

• Seventy-three percent of all leases held by U.S. public companies ($1.1 trillion)involve the leasing of real estate. (CFO.com)

In its Report, the SEC noted that because of ASC 840’s bright-line tests (90 percent, 75percent, etc.), small differences in economics can completely change the accounting(capital versus operating) for leases.

Keeping leases off the balance sheet while still retaining tax benefits has been anindustry unto itself. So-called synthetic leases have been commonly used to maximizethe tax benefits of a lease while not capitalizing the lease for GAAP purposes. Inaddition, lease accounting abuses have been the focus of restatements with approxi-mately 270 companies, mostly restaurants and retailers, restating or adjusting theirlease accounting in the wake of Section 404 implementation under Sarbanes-Oxley.

Retailers have the largest amount of operating lease obligations outstanding thatare not recorded on their balance sheets, as noted in the following table:

Operating Leases Obligations Outstanding—Major Retailers

LeaseObligations

Retailer (in millions)

Office Depot Inc. $1,104

Walgreens Co. 27,434

CVS 38,917

Whole Foods 6,322

Sears 7,608

Source: Annual Reports

¶105

http://CFO.com

3MODULE 1 - CHAPTER 1 - Changes to Lease Accounting

The above table shows the amount of off-balance-sheet lease obligations for some of thelargest U.S. retailers. These numbers are significant and bring to the forefront thepervasive impact the new lease standard will have on the larger retailers.

¶106 FASB-IASB LEASE PROJECTSince the Sarbanes-Oxley Act became effective, the FASB has focused on standards thatenhance transparency of transactions and that eliminate off-balance-sheet transactions,the most recent of which was the issuance of ASC 810, Consolidation of Variable InterestEntities. The FASB added to its agenda a joint project with the IASB that would replaceexisting lease accounting rules found in ASC 840 and its counterpart in Europe, IASBNo. 17. The FASB and IASB started deliberations on the project in 2007, and issued adiscussion memorandum in 2009, followed by the issuance of an exposure draft in 2010entitled, Leases (Topic 840).

The 2010 exposure draft was met with numerous criticisms that compelled theFASB to issue a second, replacement exposure draft on May 16, 2013 entitled Leases(Topic 842), a revision of the 2010 proposed FASB Accounting Standards Update, Leases(Topic 840). Following are some of the changes that the FASB and IASB have includedin their new lease model as outlined in the May 2013 Exposure Draft.

¶107 BASIC CONCEPTS OF ASU 2016-02 LEASES(TOPIC 842)The core principle of the requirements found in ASU 2016-02 is that an entity should usethe right-of-use model to account for leases which will require the entity to recognizeassets and liabilities arising from a lease. Thus, most existing operating leases will bebrought onto the balance sheet.

In accordance with the right-of-use model, a lessee will recognize assets andliabilities for any leases that have a maximum possible lease term of more than 12months. Leases with terms of 12 months or less will have the option of remaining asoperating leases.

Following the study questions is a summary of the key elements of the new leasestandard.

STUDY QUESTIONS

1. Under existing GAAP (Leases (ASC 840)), in order for a lease to qualify as a capitallease, which one of the following conditions must be satisfied?

a. The future value of the minimum lease payments must be equal to or exceed10 percent or more of the fair value of the asset.

b. The lease term must be no more than 50 percent of the remaining useful life ofthe leased asset.

c. There must be a bargain purchase at the end of the lease.

d. There must not be a transfer of ownership.

2. Which of the following models does the new lease standard use?

a. Right-of-use model

b. Operating lease model

c. Capital lease model

d. True lease model

¶107


¶108 LESSEEAt the commencement date, a lessee will measure both of the following:

• A lease liability (liability to make lease payments)

• A right-of-use asset (right to use the leased asset for the lease term)

Lease LiabilityThe lease liability will be recorded at the present value of the lease payments over thelease term, discounted using the rate the lessor charges the lessee (the lessor’s imputedrate) based on information available at the commencement date. If the lessor’s imputedrate cannot be readily determined, the lessee will use its incremental borrowing rate.

Nonpublic entities will be permitted to use a risk-free discount rate, determinedusing a period comparable to that of the lease term, as an accounting policy election forall leases. The risk-free discount rate will be a U.S. Treasury instrument rate for thesame term as the lease.

Right-of-Use AssetAt the commencement date, the cost of the right-of-use asset will consist of all of thefollowing:

• The amount of the initial measurement of the lease liability

• Any lease payments made to the lessor at or before the commencement date,less any lease incentives received from the lessor

• Any initial direct costs incurred by the lessee

At the commencement date, initial direct costs will be included as part of the cost of thelease asset capitalized and may include:

• Commissions

• Legal fees

• Evaluating the prospective lessee’s financial condition

• Evaluating and recording guarantees, collateral, and other security contracts

• Negotiating lease terms and conditions

• Preparing and processing lease documents

• Payments made to existing tenants to obtain the lease

The following items are examples of costs that will not be initial direct costs:

• General overheads (e.g., depreciation, occupancy and equipment costs, unsuc-cessful origination efforts, and idle time)

• Costs related to activities performed by the lessor for advertising, solicitingpotential lessees, servicing existing leases, or other ancillary activities

Lease PaymentsAt the commencement date, lease payments included in the lease liability will consist ofthe following payments related to the use of the underlying asset during the lease termthat are not yet paid:

¶108


• Fixed payments, less any lease incentives receivable from the lessor

• Variable lease payments that depend on an index or a rate (such as theConsumer Price Index or a market interest rate), initially measured using theindex or rate at the commencement date

• Amounts expected to be payable by the lessee under residual value guarantees

• The exercise price of a purchase option if the lessee is reasonably certain toexercise that option

• Payments for penalties for terminating the lease, if the lease term reflects thelessee exercising an option to terminate the lease

Variable lease payments will be included in lease payments used to calculate the leaseliability if the lease payments will depend on an index or rate, such as a CPI index. Eachyear, the lessee will adjust the lease obligation to reflect the present value of theremaining lease payments using latest index in effect at the end of that year.

Lease payments based on performance (such as a percentage of sales, with nominimum) will not be reflected in the lease payments in computing the lease obligation.Instead, such payments will be recorded annually as actual sales are generated.

Lease TermAn entity will determine the lease term as the noncancellable period of the lease, togetherwith both of the following:

• Periods covered by an option to extend the lease if the lessee is reasonablycertain to exercise that option

• Periods covered by an option to terminate the lease if the lessee is reasonablycertain not to exercise that option.

Factors will be considered together, and the existence of any one factor will notnecessarily signify that a lessee is reasonably certain to exercise, or not to exercise, theoption. Examples of factors to consider will include, but will not be limited to, any of thefollowing:

• Contractual terms and conditions for the optional periods compared with cur-rent market rates

• Significant leasehold improvements that are expected to have significant eco-nomic value for the lessee when the option to extend or terminate the lease or topurchase the asset becomes exercisable

• Costs relating to the termination of the lease and the signing of a new lease,such as negotiation costs, relocation costs, costs of identifying another underly-ing asset suitable for the lessee’s operations, or costs associated with returningthe underlying asset in a contractually specified condition or to a contractuallyspecified location

• The importance of that underlying asset to the lessee’s operations, considering,for example, whether the underlying asset is a specialized asset and the locationof the underlying asset

EXAMPLE: A retail lessee, a liquor store, has a five-year lease with two,five-year options. It will be very difficult for the lessee to move the liquor storedue to neighborhood opposition. Thus, the store location is very important tothe lessee and the lessee most likely is reasonably certain to exercise theoptions so that the lease term is probably 15 years.

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An entity will reassess the lease term only if either of the following occurs:

• There is a change in relevant factors that will result in the lessee no longer beingreasonably certain to exercise an option to extend the lease or not to exercise anoption to terminate the lease.

NOTE: A change in market-based factors (such as market rates to lease acomparable asset) shall not, in isolation, trigger reassessment of the lease term.

• The lessee does either of the following:

- Elects to exercise an option even though the entity had previously determinedthat the lessee was not reasonably certain to do so

- Does not elect to exercise an option even though the entity had previouslydetermined that the lessee was reasonably certain to do so

Classification of LeasesASU 2016-02 establishes two types of leases:

Type A lease: Lease in which lessee expects to consume more than an insignificantportion of the economic benefits (life) of the asset:

• Will apply to most leases of assets other than property (e.g., equipment, aircraft,cars, trucks)

• Will recognize a right-of-use asset and a lease liability, initially measured at thepresent value of lease payments

• Will recognize the unwinding of the discount on the lease liability as interestseparately from the amortization of the right-of-use asset

• Total expense will be accelerated and shown in two expense components:

• Interest expense (accelerated)

• Amortization expense (straight-line)

Type B lease: Lease in which the lessee expects to consume only an insignificant portionof the economic benefits (life) of the asset:

• Will apply to most leases of property (i.e., land and/or a building or part of abuilding)

• Will recognize a right-of-use asset and a lease liability, initially measured at thepresent value of lease payments (same as Type A lease)

• Will recognize a single lease expense, combining the unwinding of the discounton the lease liability (interest) with the amortization of the right-of-use asset, ona straight-line basis.

• Total expense will be recorded on a straight-line basis throughout the leaseterm.

The following chart compares the new standard with existing GAAP for leases.

Comparison of Existing GAAP Versus New GAAP for Leases Lessee Side

Description Current GAAP for Operating Leases New GAAP

Lease type Leases are classified as operating or capital All leases classified as financingleases (financing arrangements) based on arrangements (as if assetsatisfying one of four criteria: purchases)

• 75% rule Right-of-use asset and lease • 90% rule liability recorded at present • Bargain purchase value of payments over the • Transfer of ownership lease term

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Comparison of Existing GAAP Versus New GAAP for Leases Lessee Side

Description Current GAAP for Operating Leases New GAAP

Lease term Non-cancellable periods Non-cancellable period togetherOption periods generally not included in with any options to extend orlease term terminate the lease when it is

reasonably certain that thelessee will exercise an option toextend the lease

Contingent/variable Contingent rents excluded from lease Variable rents included in leaserents payments. When paid, they are period payments in certain instances

costs.

Income statement Operating leases: lease expense straight- Two Approaches:line basis TYPE A LEASE: Interest andCapital leases: depreciation and interest amortization expenseexpense recorded—Accelerated expense

TYPE B LEASE: Lease expense

recorded as combination ofinterest and amortization—straight-line expense

Assessment Terms are not re-assessed Leases reassessed in certaininstances

STUDY QUESTION

3. Facts: A company is a lessee of a lease with a lease term of 12 months. How may thelessee account for this lease under the new lease standard?

a. The company is required to record a lease asset and liability.

b. The company is required to record the lease as an operating lease.

c. The company has the option to record the lease asset and liability, or recordthe lease as an operating lease.

d. The new standard does not address lease terms of 12 months or less.

¶109 SHORT-TERM LEASESA lessee will not be required to recognize lease assets or lease liabilities for short-termleases. A short-term lease is defined as follows:

A lease that, at the date of commencement of the lease, has a maximumpossible term, including any options to renew, of 12 months or less.

For short-term leases, the lessee will recognize lease payments as rent expense in theincome statement on a straight-line basis over the lease term, unless another systematicand rational basis is more representative of the time pattern in which use is derivedfrom the underlying asset.

NOTE: The new standard will treat short-term leases (12 months or less) asoperating leases by not requiring the lessee to record the lease asset and liability.Instead, rent expense will be recorded on a straight-line basis as incurred, althoughthe new standard permits an entity to use another approach (other than a straight-line method) to record rent expense if that alternative is more representative of thetime pattern in which the lessee uses the lease asset.

A lessee will be permitted (but is not required) to record a lease asset andliability for a short-term lease. Lessors will be permitted to elect to account for all

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short-term leases by not recognizing lease assets or lease liabilities and by recog-nizing lease payments received in rental income on a straight-line basis over thelease term, or another systematic and rational basis that is more representative ofthe time pattern in which use is derived from the underlying asset.

¶110 DISCLOSURESBoth lessees and lessors will provide disclosures to meet the objective of enabling usersof financial statements to understand the amount, timing, and uncertainty of cash flowsarising from leases.

¶111 EFFECTIVE DATE AND TRANSITIONASU 2016-02 is effective for fiscal years beginning after December 15, 2018, includinginterim periods within those fiscal years, for any of the following:

• A public business entity

• A not-for-profit entity that has issued, or is a conduit bond obligor for, securitiesthat are traded, listed, or quoted on an exchange or an over-the-counter market

• An employee benefit plan that files financial statements with the U.S. Securitiesand Exchange Commission (SEC).

For all other entities, the amendments in this ASU are effective for fiscal yearsbeginning after December 15, 2019, and interim periods within fiscal years beginningafter December 15, 2020. Early application is permitted for all entities.

Existing leases will not be grandfathered thereby requiring existing operatingleases to be brought onto the balance sheet. All existing outstanding leases will berecognized and measured at the date of initial application using a simplified retrospec-tive approach. On transition, a lessee and a lessor will recognize and measure leases atthe beginning of the earliest period presented using either a modified retrospectiveapproach or a full retrospective approach.

¶112 IMPACT OF CHANGES TO LEASE ACCOUNTINGThe lease accounting changes could be devastating to many companies and may resultin many more leases being capitalized which will impact all financial statements.Retailers, in particular, will be affected the most. If leases of retailers, for example, arecapitalized, the impact on financial statements will be significant, as noted below:

• Lessee’s balance sheets will be grossed up for the recognized lease assets andthe lease obligations for all lease obligations.

NOTE: Including contingent lease payments and renewal options mayresult in overstated liabilities given the fact that contingent payments must beincluded in the lease payments and renewal options must be considered indetermining the lease term.

• For Type A leases, lessee’s income statements will be adversely affected withhigher lease expense in the earlier years of new leases. On average, a 10-yearlease will incur approximately 15-20 percent higher annual lease expense in theearlier years, if capitalized, as compared with an operating lease. That higherlease amount will reverse in the later years.

• For Type A leases, on the statement of cash flows, there will be a positive shift incash flow to cash from operations from cash from financing activities. A portionof rent expense previously deducted in arriving at cash from operations will nowbe deducted as principal payments in cash from financing activities. Thus,

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companies will have higher cash from operating activities and lower cash fromfinancing activities.

• In most cases, annual lease expense for GAAP (interest and amortization) willnot match lease expense for income tax purposes thereby resulting in deferredincome taxes.

Changes to both the balance sheets and income statements of companies will haverippling effects on other elements of the lessee companies. On the positive side, alessee’s earnings before interest, taxes, depreciation and amortization (EBITDA) mayactually improve as there is a shift from rent expense under operating leases to interestand amortization expense under the new standard.

• Both interest and amortization expense is not deducted in arriving at EBITDAwhile rent expense is.

• Changes in EBIDTA may affect existing agreements related to compensation,earn outs, bonuses, and commissions.

On the negative side, for Type A and B leases, lessee debt-equity ratios will be affectedwith entities carrying significantly higher lease obligation debt than under existingGAAP. Higher debt-equity ratios could put certain loan agreements into default. Moreo-ver, net income will be lower in the earlier years of the lease term due to higher interestand amortization expense replacing rental expense.

How significant will the change to the new lease standard be forU.S. companies?As previously noted, there are approximately $1.5 trillion of operating lease obligationsthat are not recorded on public company balance sheets. That $1.5 trillion is magnifiedby the many nonpublic companies that have unpublished operating lease obligationsthat are unrecorded. The author estimates that unrecorded lease obligations of nonpub-lic operating leases is at least another $1.3 trillion bringing to estimated total unre-corded lease obligations at approximately $2.8 trillion.

Consider the following estimated impacts of shifting those operating leases tocapitalized right-of-use leases (Report issued by Change & Adams Consulting, commis-sioned by the U.S. Chamber of Commerce, and others (2012)):

• Earnings of retailers will decline significantly. One recent study suggested thatthere will be a median drop in EPS of 5.3 percent and a median decline in returnon assets of 1.7 percent.

• Public companies could face $10.2 billion of added annual interest costs.

• There could be a loss of U.S. jobs in the range of 190,000 to 3.3 million.

• Cost of compliance with the new standard could lower U.S. GDP by $27.5 billiona year.

• Lessors could lose approximately $14.8 billion in the value in their commercialreal estate.

• Balance sheets could be loaded with significant lease obligations that wouldimpact debt-equity ratios ( Bear Stearns research study).

- Aggregate debt of nonfinancial S&P 500 companies could increase by 17percent if all leases were capitalized.

- Return on assets could decline as total assets (the denominator) could increaseby approximately 10 percent.

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- The S&P 500 could record an estimate of $549 billion of additional liabilitiesunder the new lease standard on existing operating leases (Leases Landing onBalance Sheet (Credit Suisse)).

- U. S. companies, as a whole (public and nonpublic), could record approxi-mately $7.8 trillion of additional liabilities if operating leases are capitalized(Author’s estimate: $1.5 trillion for public companies and $6.3 trillion for non-public companies).

According to a Credit Suisse study, (Leases Landing on Balance Sheet (Credit Suisse)),there are 494 of the S&P 500 companies that are obligated to make $634 billion of totalfuture minimum lease payments under operating leases. On a present value basis,including contingent rents, the $634 billion translates into an additional liability underthe new standard of $549 billion. Of the $549 billion of additional liabilities, 15 percent ofthat total relates to retail companies on the S&P 500.

In some cases, the effect of capitalizing lease obligations under the new leasestandard is that the additional liability exceeds stockholders’ equity.

Consider the following table:Impact of Capitalizing Leases—Selected Retailers Based on Annual Reports

AdditionalPV converter liability

Operating lease 5 years under new lease Stockholders’Retailer obligations 4% (a) standard equity % equity

Office Depot Inc. $ 2 B .822 $1.6 B $661M 248%

Walgreens Co. 35 B .822 28.8 B 18 B 160%

CVS 28 B .822 23.0 B 38 B 61%

Whole Foods 6.8 B .822 5.6 B 3.8 B 147%

Sears 4.5 B .822 3.7 B 3.1 B 119%

Source: Annual Reports, as obtained by the author.(a) Assumes the weighted-average remaining lease term is five years, and the incremental borrowingrate is four percent

The previous table identifies the sizeable problem that exists for many U.S. retailerswhich is that there are huge off-balance-sheet operating lease liabilities as a percentageof company market capitalization. Under the proposed lease standard, these obligationswould be recorded, thereby having a devastating impact on those retailers’ balancesheets. For example, look at Office Depot and its $1.6 billion lease liability that wouldrepresent 248% of its stockholders’ equity of $661 million.

How will the new lease standard impact how leases are structured?Companies are going to consider the balance sheet impact when structuring leases andin deciding whether to lease or buy the underlying asset. There are several likelyactions that will come from the new standard:

Lease-versus-buy decision impacted: By implementing the new standard, theGAAP differences between leasing and owning an asset will be reduced. Having tocapitalize all leases may have a significant effect on the lease versus purchase decision,particularly with respect to real estate. Tenants, in particular those in single-tenantbuildings with long-term leases, may choose to purchase a building instead of leasing it:

• A similar amount of debt will be included on the tenant’s balance sheet under along-term lease as compared with a purchase.

• GAAP depreciation under a purchase may actually be lower than amortizationunder a lease because the amortization life under the lease (generally the leaseterm) is likely to be shorter than the useful life under a purchase.

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EXAMPLE: Assume there is a 10-year building lease with two, five-yearlease options, resulting in a maximum lease term of 20 years. Assume furtherthat the useful life of the building is 30 years for depreciation purposes. If theentity leases the real estate, the right-of-use asset will be amortized over amaximum of 20 years. If, instead, the entity were to purchase the real estate, thebuilding will be depreciated over the useful life of 30 years.

NOTE: In some instances, lessees may choose to purchase the leased assetrather than lease it, if the accounting is the same. In particular, the purchasescenario may be more appealing for longer-term leases that have significant debtobligations on the lessee balance sheets. Lessees with shorter-term leases willnot be burdened with the extensive debt obligations and, therefore, may choosenot to purchase the underlying lease asset.

Lease terms are likely to shorten: For many companies who do not wish to purchasethe underlying leased asset, lease terms may shorten to reduce the amount of the leaseobligation (and related asset) that is recorded at the lease inception. The new leasestandard will affect not only the landlords and tenants, but also brokers, as there will bemuch greater emphasis placed on executing leases for shorter periods of times therebyincreasing the paperwork over a period of time and the commissions earned.

Deferred tax assets will be created: Because many operating leases will now becapitalized for GAAP but not for tax purposes, total GAAP expense (interest andamortization) will be greater than lease expense for tax purposes, resulting in deferredtax assets for the future tax benefits that will be realized when the temporary differencereverses in later years.

Under existing GAAP, most, but not all, operating leases are treated as operatingleases for tax purposes. Therefore, rarely are operating leases capitalized for taxpurposes. Now the game is about to change if operating leases are capitalized as right-of-use assets under GAAP, while they continue to be treated as operating leases for taxpurposes. As we have seen in the previous examples, most leases capitalized under thenew standard will result in the creation of a deferred tax asset.

STUDY QUESTIONS

4. Which of the following will be a probable effect of the new lease standard?

a. The lessee’s income statement will have lower total lease expense in the earlieryears of new leases.

b. There will be a negative shift in cash from operations from cash from financingactivities in the statement of cash flows.

c. In most cases, total expense for GAAP will be the same as total expense forincome tax purposes.

d. The lessee’s EBITDA may increase as there is a shift from rent expense tointerest and amortization expense.

5. One change that may occur as a result of the new lease standard being implementedis:

a. Companies that typically purchase a single-tenant building may choose to leaseinstead of buy.

b. Tenants in multi-tenant buildings will likely sign longer-term leases.

c. Tenants in single-tenant buildings with long-term leases may choose to buy.

d. There is likely to be no change.

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6. Annual GAAP depreciation expense for a purchase of a leased asset may be______________ assuming there is a Type A lease.

a. Higher than annual amortization expense under a lease

b. Lower than annual amortization expense under a lease

c. The same as annual amortization expense under a lease

d. Either higher or lower than amortization expense under a lease, depending onwhether options are part of the lease term

Dealing with Financial CovenantsThe new lease standard will cast a wide web across the accounting profession. Bycapitalizing leases that were previously off-balance-sheet as operating leases, there maybe consequences.

EXAMPLES:

• Impact on state apportionment computations: Many states compute the apportion-ment of income assigned to that state using a property factor based on real andtangible personal property held in that particular state.

NOTE: When it comes to rent expense, most states capitalize the rentsusing a factor such as eight times rent expense. Although each state has its ownset of rules, the implementation of the new standard may have a sizeablepositive or negative impact on state tax apportionment based on shifting rentexpense to capitalized assets.

• Impact on tax planning: Capitalizing leases might have a positive effect in taxplanning.

NOTE: One example is where there is a C corporation with accumulatedearnings and exposure to an accumulated earnings tax (AET). The additionallease obligation liability will certainly help justify that the accumulation ofearnings is not subject to the AET.

• Impact on total asset and liability thresholds: Companies should also be awarethat not only will the new standard increase liabilities, but will also increase totalassets.

NOTE: In some states, there are total asset thresholds that drive highertaxes and reporting requirements.

A critical impact of the new standard will be that certain loan covenants may beadversely impaired, thereby forcing companies into violations of their loans.

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Consider the following ratios:Likely impact of new

Ratio lease standard

EBITDA:

Earnings before interest, taxes, depreciation Type A Leases:and amortization Favorable impact due to shift from rental expense

to interest and amortization expense, both ofwhich are added back in computing EBITDAType B Leases:May be favorable impact depending on whether“lease expense� is added back to computeEBITDA

Interest coverage ratio: May be negatively impacted from lower ratio

Earnings before interest and taxes

Interest expense

Debt-equity ratio: Negative impact from higher ratio

Total liabilities

Stockholders’ equity

There will be a favorable impact on EBITDA for Type A leases by implementing the newstandard. Rent expense recorded for operating leases under existing GAAP will bereduced while interest expense and amortization expense will increase once the leasesare capitalized.

However, the issue is what happens to EBITDA for Type B leases. Under theproposal, interest and amortization are combined as one line item on the incomestatement entitled “lease expense.� The question is whether that line item is added backin arriving at EBITDA. Perhaps it should be added back because it represents interestand amortization despite the lease expense label.

As to the interest coverage ratio, the impact on the ratio depends on the whetherthere is a Type A or B lease. For a Type A lease, earnings before interest and taxes willlikely be higher as rent expense is removed and replaced with interest and amortizationexpense. For Type A leases, the denominator increases significantly due to the higherinterest expense. On balance, the slightly higher earnings before interest and taxesdivided by a higher interest expense in the denominator yields a lower interestcoverage ratio.

For a Type B lease, the impact on the ratio is unclear. Although interest expense,along with amortization expense, will be embedded in the caption line item “leaseexpense,� most analysts will likely carve out the interest and amortization componentsand adjust the interest coverage ratio by the interest portion.

Perhaps the most significant impact of capitalizing leases under the new leasestandard will be its effect on the debt-equity ratio. With sizeable liabilities beingrecorded, this ratio will likely turn quite negative and severely impact company balancesheets. In some cases, the debt-equity ratio will result in violation of existing loancovenants, thereby requiring a company to renegotiate the covenants with its lenders orat least notify lenders in advance of the likely lack of compliance with loan covenants.

What about the impact on smaller nonpublic entities?One leasing organization noted that more than 90 percent of all leases involve assetsworth less than $5 million and have terms of two to five years (Equipment Leasing andFinancing Association (ELFA) “Companies: New Lease Rule Means Labor Pains� (CFO.com)). That means that smaller companies have a significant amount of leases, most ofwhich are currently being accounted for as operating leases.

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http://CFO.com

http://CFO.com


Unless these smaller, nonpublic entities choose to use the income tax basis fortheir financial statements, under GAAP, these companies will be required to capitalizetheir operating leases.

What about related party leases?Some, but not all, related party leases result in the lessee (parent equivalent) consolidat-ing the lessor (subsidiary equivalent) under the consolidation of variable interest entityrules (ASC 810). The common example of a related-party lease is where an operatingcompany lessee leases real estate from its related party lessor. In general, under ASC810, if there is a related party lessee and lessor, consolidation is required if:

• The real estate lessor is a variable interest entity (VIE) (e.g., it is not self-sustaining), and,

• The lessee operating company and/or the common shareholder provide finan-cial support to the real estate lessor in the form of loans, guarantees of bankloans, above-market lease payments, etc.

If these two conditions are met, it is likely that the real estate lessor must beconsolidated in with the operating company lessee’s financial statements. If there isconsolidation, capitalizing the lease under the new standard will be moot because theasset, liability, and lease payments will be eliminated in the consolidation.

In 2014, the Private Company Council (PCC) issued ASU 2014-07 which providesprivate (nonpublic) entities an election not to apply the consolidation of VIE rules to arelated-party lease arrangement. When implemented, the ASU should provide mostprivate companies with relief from the VIE rules for related party leases. Thus, mostprivate (nonpublic) entities involved in related-party leases will not be consolidating thelessor into the lessee.

When it comes to a related-party lease in which there is no consolidation, theparties will have to account for that lease as a right-of-use lease asset and obligation, justlike any other lease transaction. Consequently, under the new standard, the operatingcompany lessee will be required to record a right-of-use asset and lease obligation basedon the present value of the lease payments.

Many related parties either do not have formal leases or the leases are short-term.If the operating company lessee is going to have to record a significant asset andliability, it may make sense to have a related-party lease that has a lease term of 12months or less or is a tenant-at-will arrangement.

With respect to a related party lease that is 12 months or less, the new standard willpermit (but not require) use of the short-term lease rules as follows:

• A lessee will treat the short-term lease as an operating lease with no recognitionof the lease asset or lease liability. The rental payments will be recognized asrent expense on a straight-line basis.

• On the lessor side, the lessor will record rental income on a straight-line basisand not record the lease asset and liability.

• Either the lessee or lessor could elect to record the lease asset and liabilityusing the new standard rules.

With many related-party leases, the operating company lessee may issue financialstatements while the real estate lessor does not. Therefore, how the lessee accounts forthe transaction under GAAP may be more important than the lessor’s accounting for thetransaction.

EXAMPLE: Company X is a real estate lessor LLC that leases an officebuilding to a related-party operating Company Y. X and Y are related by a common

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owner. The companies sign an annual 12-month lease with no renewals, and noobligations that extend beyond the twelve months. Monthly rents are $10,000. Yissues financial statements to its bank while X does not issue financial statements.Y chooses ASU 2014-07’s election not to consolidate X into Y’s financial statements.

Because the entities have a short-term lease of 12 months or less, Y, as lessee,will qualify for the short-term lease rules. Therefore, Y will not record a lease assetand liability and, instead, will record the monthly rent payments and rent expenseon a straight-line basis over the short-term lease period. Alternatively, Y could electto treat the short-term lease as a standard lease by recording both the lease assetand liability.

As to the lessor, it will also not record the lease asset and liability and, instead,will record rental income on a straight-line basis over the 12-month period.

OBSERVATION: Many nonpublic entities may take steps to avoid the newstandard’s arduous rules. One approach will likely be to make sure the related-party leases have terms that are 12 months or less so that the lease can be treatedas an operating lease and not capitalized. Another approach will be to issue incometax basis financial statements.

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17

MODULE 1: ONGOING ISSUES—CHAPTER2: Simplifying Inventory Measurement¶201 WELCOMEThis chapter provides an overview of the accounting and reporting amendments withrespect to Accounting Standards Update 2015-11 released by the FASB in July 2015.This ASU is part of the FASB’s Simplification Initiative and applies to entities thatmeasure their inventory using either the first-in first-out (FIFO) or average costmethods. The ASU did not make changes to inventories measured using either last-infirst-out (LIFO) or the retail inventory method.



• Identify the measurement basis used to measure FIFO and LIFO inventoriesunder ASU 2015-11

• Recognize how to account for a recovery of an inventory write-down in subse-quent periods

• Identify the method to be used to implement ASU 2015-11 for inventory

¶203 INTRODUCTIONThe FASB received comments from users that the current guidance on the measure-ment of inventory is unnecessarily complex because there are three potential outcomesto determine the market used in the lower of cost or market comparison. As a result,ASU 2015-11 was issued in order to simplify the measurement of inventory. This ASU,effective for fiscal years beginning after December 15, 2016, and interim periods withinthose annual periods (one year later for nonpublic entities), is part of the FASB’sSimplification Initiative. The objective of the Simplification Initiative is to identify,evaluate, and improve areas of U.S. GAAP for which cost and complexity can bereduced, while maintaining or improving the usefulness of the information provided tousers of financial statements.

ASC 330 (“Inventory�) presently requires an entity to measure inventory at thelower of cost or market. Currently within ASC 330, market could be any one of threeoutcomes: replacement cost, net realizable value, or net realizable value less normalprofit margin. The determination of the market is subject to a range. The upper amountof the range (the ceiling) is net realizable value (selling price less costs to dispose (sell),transportation, and costs of completion). The floor is net realizable value less the normalprofit margin.

Replacement cost is market subject to a ceiling and floor computed as follows:

Selling price $XX

Costs of completion, disposal, and transportation (XX)

NET REALIZABLE VALUE- MARKET CEILING XX

Normal profit margin (XX)

MARKET FLOOR $XX

In computing market, replacement cost is compared to the range noted above inorder to determine the market price used in the lower of cost or market assessment. If

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replacement cost is within the ceiling and floor range, replacement cost is consideredmarket and compared with cost to determine lower of cost or market. However, ifreplacement cost is greater than the ceiling, the ceiling is considered the market priceand is used in the comparison. Finally, if replacement cost is lower than the floor, thefloor is considered the market. Refer to the following example for an illustration of thismethod of determining the market.

EXAMPLE: Item 1 Item 2

Cost $40 $60

Replacement Cost 50 70

Ceiling 55 55

Floor 45 45

Market

Replacement Cost $50

Ceiling $55

Lower of Cost or Market $40 $55

¶204 CHANGES RESULTING FROM THE ASUWhile the FASB decided to simplify the model to reduce costs and increase comparabil-ity for inventory measured at FIFO or average cost, the FASB chose to exclude from thenew rules inventory measured using LIFO or the retail inventory method. As a result,for FIFO and average cost inventory cost is compared with net realizable value. ForLIFO and average cost, the existing lower of cost or market approach was retained (i.e.three potential outcomes).

The amendments in the ASU make U.S. inventory valuations more closely alignedwith the measurement of inventory in International Financial Reporting Standards(IFRS). Other than the change in the measurement guidance from the lower of cost ormarket to the lower of cost and net realizable value for inventory within the scope of theASU, there are no other substantive changes made by the ASU to the measurement ofinventory.

STUDY QUESTIONS

1. Company Z uses LIFO for its inventory valuation and measures its inventory at lowerof cost or market. Because Company Z uses the LIFO inventory valuation method,market is defined as which of the following?

a. Fair value

b. Replacement cost with ceiling and floor limits

c. Net realizable value

d. Normal profit

2. When calculating net realizable value, estimated selling price is adjusted for whichof the following?

a. Less normal profit

b. Less costs of completion

c. Less fixed costs

d. Plus discounts and allowances

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19MODULE 1 - CHAPTER 2 - Simplifying Inventory Measurement

¶205 SUBSEQUENT MEASUREMENTThe method used for the subsequent measurement of inventory depends on the costmethod being used by the entity. As a result, the subsequent measurement of inventoryis different for the each of the following:

• Inventory measured using LIFO or the retail inventory method

• Inventory measured using any method other than LIFO or the retail inventorymethod

When evidence exists that the net realizable value of inventory is lower than its cost, thedifference is recognized as a loss in earnings in the period in which it occurs. This losscan be driven by damage, physical deterioration, obsolescence, changes in price levels,or other causes.

FIFO or the Retail Inventory MethodFor inventory measured using LIFO or the retail inventory method, an entity shouldcontinue to measure the inventory at the lower of cost or market. A departure from thecost basis of pricing inventory measured using LIFO or the retail inventory method isrequired when the utility of the goods is no longer as great as their cost.

Applicable to All Inventory Valuation MethodsIf inventory has been the hedged item in a fair value hedge, the inventory’s cost basisfor purposes of subsequent measurement is required to reflect the effect of theadjustments of its carrying amount made in accordance with ASC 815-25-35-1(b).

COMMENT: ASC 815-25-35-1(b) states that the gain or loss (based on thechange in fair value) on a hedged item attributable to the hedged risk shall adjustthe carrying amount of the hedged item and is recognized currently in earnings.

Once inventory has been written down to either cost or its net realizable value, thewritten down amount becomes the new cost and cannot be reversed under U.S. GAAP.This is contrary to IFRS which permits the write-down to be reversed up to the originalcost. The SEC Staff Accounting Bulletin (SAB) Topic 5. BB-Inventory Valuation Allow-ance (ASC 330-10-S99-2) addresses the issue of restoration of write-downs under theprevious lower of cost or market rules. The conclusion still applies to the new lower ofcost and net realizable value requirements in ASU 2015-11.

Question: Does the write-down of inventory to the lower of cost or market, asrequired by FASB ASC Topic 330, create a new cost basis for the inventory, or maya subsequent change in facts and circumstances allow for restoration of inventoryvalue, not to exceed original historical cost?

Interpretative Response: Based on FASB ASC paragraph 330-10-35-14, awrite-down of inventory to the lower of cost or market at the close of a fiscal yearcreates a new basis that subsequently cannot be marked up based on changes inunderlying facts and circumstances.

Depending on the character and composition of the inventory, the lower of cost ormarket inventory measurement can be applied using any of the following three ap-proaches. The appropriateness of the various approaches is based on which one mostclearly reflects periodic income. The measurement can be applied:

• Directly to each individual item

• To the total inventory

• To the total of the components of each major category of inventory

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In principle, the purpose of reducing the carrying amount of inventory is to reflect fairlythe income of the period. The most common practice is to apply the applicablesubsequent measurement guidance separately to each item of the inventory. However,if there is only one end-product category, the application of the applicable subsequentmeasurement guidance to inventory in its entirety may have the greatest significancefor accounting purposes. Similarly, where more than one major product or operationalcategory exists, the application of the applicable subsequent measurement guidance tothe total of the items included in such major categories may result in the most usefuldetermination of income. It is also important to note that Internal Revenue Code (Code)requires that the lower of cost or market test be performed on an individual-item basisand not for the inventory as a whole.

Additionally, it is important to understand the accounting requirements for marketdeclines in interim periods. In this situation, if near-term price recovery is uncertain, adecline in the market value (for inventory measured using LIFO or the retail inventorymethod) or net realizable value (for all other inventory) of inventory below cost duringan interim period should be accounted for consistently with annual periods.

EXAMPLE: Company X is a distributor of wholesale products which arecomplete and ready to sell. However, the selling prices of certain items within itsinventory have declined due to competition. The costs to dispose (sell) andtransport as a percentage of gross sales are as follows:

Commissions 8%

Freight out 4%

Sales discounts and allowances 3%

15%

The company had no write-down of inventory in the prior year, 2016. AtDecember 31, 2017, inventory information for its five products (A, B, C, D and E) isas follows:Product A B C D E

Cost- FIFO $110 $155 $165 $140 $70

NRV:

Estimated selling price $140 160 180 120 100

Cost to dispose and transportation (15%) (21) (24) (27) (18) (15)

Net realizable value $119 $136 $153 $102 $85

Computation of Lower of Cost and Net Realizable ValueDecember 31, 2017

Quantity Unit cost NRV Total cost Total at NRV Lower of costProduct (a) (b) (c) (a) x (b) (a) x (c) and NRV

A 1,000 $110 $119 $110,000 $119,000 $110,000

B 2,000 155 136 310,000 272,000 272,000

C 3,000 165 153 495,000 459,000 459,000

D 4,000 140 102 560,000 408,000 408,000

E 2,000 70 85 140,000 170,000 140,000

$1,615,000 $1,428,000 $1,389,000

If the company computes the lower of cost and net realizable value on an individualproduct basis, the write-down is calculated as follows:

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Inventory at cost $1,615,000

Inventory at NRV 1,389,000

Write-down $(226,000)

Entry at December 31, 2017:

Cost of goods sold- inventory write-down 226,000

Allowance for inventory write-down 226,000

Note that the entry could also be recorded as a credit directly to inventory without theuse of an inventory allowance account.

Alternatively, if the company computes lower of cost and net realizable value basedon the total inventory (i.e. not on an individual product basis), the write-down iscalculated as follows:







STUDY QUESTION

3. If Company M uses the FIFO method of inventory valuation and has adopted theamendments of ASU 2015-11, then the company should always measure its inventory aswhich of the following?

a. Net realizable value

b. Lower of cost and net realizable value

c. Replacement cost

d. Lower of cost or fair value

Challenge for ManufacturersA manufacturer has a challenge in applying the ASU if it uses FIFO or average cost tovalue its inventory. Because the computation is based on the lower of cost and netrealizable value, the only way to perform the test is to do so in total for the entireinventory, either by segment or in total. Performing a lower of cost and net realizablevalue on an individual-item basis is not possible if there are raw materials. The primereason is because replacement cost is no longer used in the computation. As a result, anentity must compute net realizable value. Because raw materials become part of finishedgoods, net realizable value must be computed based on the final finished goods product,and cannot be performed on raw materials, by itself.

EXAMPLE: Company X is a manufacturer which has the following inventoryat December 31, 2017:

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Raw materials (RM) $5,000,000

Work in process (WIP) 1,000,000

Finished goods (FG) 4,000,000

$10,000,000

Costs to dispose (sell) and transportation as a percentage of gross sales, are asfollows:

Commissions 8%

Freight out 4%

Sales discounts and allowances 3%

15%

Additionally, costs of completion are as follows:

• Direct labor to convert WIP inventory to FG inventory: $200,000

• Direct labor to convert RM to FG inventory: 80% of materials cost

• Fixed and variable overhead: Allocated based on 50% of materials and laborin finished goods inventory

Company X’s computation of lower of cost and net realizable value is asfollows:

Estimated sales of all inventory upon conversion to finished goods (given) $22,000,000

Costs to dispose (sell) and transportation (15% x (3,300,000)$22,000,000)

Costs to complete: Conversion of RM and WIP to FG:

Direct labor to convert WIP to FG (see a) 200,000

Direct labor to convert RM to FG (see b) 4,000,000

Fixed overhead – to convert RM and WIP to 5,100,000finished goods (see c)

Total costs to convert RM and WIP to FG (9,300,000)

Net realizable value $9,400,000


Lower of cost and net realizable value $9,400,000

(a): Additional labor required to complete the WIP inventory to finished goods is $200,000.

(b): Information given is that direct labor in the finished product is 80% of materials cost:RM cost $5,000,000 x 80% = $4,000,000.

(c): Fixed and variable overhead is 50% of direct labor and materials in finished goodsinventory.Fixed and variable overhead is allocated to RM and WIP upon completion as finishedgoods:

RM cost $5,000,000 + direct labor $4,000,000 = $9,000,000 x 50% = $4,500,000WIP: $1,000,000 + direct labor $200,000 = $1,200,000 x 50% = $600,000Total fixed overhead to complete inventory: $4,500,000 + $600,000 = $5,100,000.

The entry to adjust the inventory to the lower of cost and net realizable valueis as follows:




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As shown in the example above, a manufacturer must test lower of cost and netrealizable value in the aggregate for all inventory, including raw materials. The reason isbecause the test must be based on net realizable value and no longer involves use ofreplacement cost.

When raw materials inventory exists, that inventory must be included in an overalltest that includes finished goods and work-in-process inventory. That test is performedby working backwards from final estimated sales at the finished goods level, reduced bycosts to complete, dispose (sell) and transport, to arrive at net realizable value. Al-though it is relatively easy to compute net realizable value if only finished goods andwork-in-process inventory exists, it is far more difficult for raw materials inventory. As aresult, the question is whether an entity must consider lower of cost and net realizablevalue with respect to raw materials inventory if that inventory is not material to theoverall inventory.

There may be instances in which a test of raw materials for lower of cost or netrealizable value may not be required when those materials will be ultimately part offinished goods inventory. This could be the case with either of the following:

• Materials cost is not significant to the total product and/or not significant incomparison to the inventory as a whole, or

• Evidence indicates that there is no write-down of work-in-process and finishedgoods inventory to lower of cost and net realizable value.

If raw materials inventory is not a significant component of the ending finished goodsproduct, an entity should be able to test lower of cost and net realizable value forfinished goods and work-in-process inventory only, and exclude any raw materialinventory in that test. The assumption is that if raw materials inventory is not significant,any possible write-down would not be significant as a result.

What if raw materials inventory is significant though? In this instance, ASC330-10-35-10 provides limited guidance as follows:

“When no loss of income is expected to take place as a result of a reduction ofcost prices of certain goods because others forming components of the samegeneral categories of finished products have a market value (for inventorymeasured using LIFO or the retail inventory method) or net realizable value(for all other inventory) equally in excess of cost, such components need not beadjusted . . . .”

Although the above citation is not precisely on point with raw materials inventory,the substance of the message is essentially the same. If raw material inventory is asignificant component of finished goods and work-in-process inventory, it would appearthat an entity could avoid testing that raw material inventory as part of an overall lowerof cost and net realizable value if evidence exists that the finished goods and work-in-process inventory has no write-down when tested. After all, the raw materials inventoryultimately becomes part of the work-in-process and finished goods inventory. If an entityfirst tests work-in-process and finished goods inventory for lower of cost and netrealizable value and there is no write-down, that would suggest that a component of thatinventory (materials cost) should have no impairment, as well.

COMMENT: The previous example illustrated a test of lower of cost or netrealizable value for a manufacturer. In looking at that test, extensive work is

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required to gather information when raw materials inventory exists and is includedin the test. For example, costs to complete the raw materials inventory (e.g.,convert the raw materials to finished goods inventory) must be calculated. Thosecosts to complete include direct labor and fixed and variable overhead. Eliminatingraw materials inventory from that test altogether saves considerable time. As aresult, the author believes that with respect to a manufacturer, an entity should dothe following:

1. Perform a test of lower of cost and net realizable value on finished goodsand work-in-process inventory, without consideration of raw materialsinventory.

2. If the test above shows no write-down of finished goods and work-in-process inventory, there should be no need to include raw materialsinventory in the lower of cost and net realizable value test.

The theory behind this approach is that raw materials inventory ultimatelybecomes part of work- in-process and finished goods inventory. If there is noindication of an impairment of work-in-process and finished goods inventory (e.g.,cost exceeds net realizable value), that should indicate that the raw materialscomponent also has no impairment.

STUDY QUESTION

4. Which of the following identifies the primary challenge for a manufacturer inimplementing the amendments of the ASU if it uses the FIFO or average cost to valueits inventory and it uses raw materials in manufacturing its finished goods?

a. The only way to perform the test is to do so in total for the entire inventory.

b. The test must be performed on an individual item basis.

c. Replacement cost cannot be readily determined.

d. Net realizable value must be computed based on work in process.

ASU 2015-11 Versus IRS RulesCode Sec. 1.471-4 Inventories at Cost or Market, whichever is Lower, permits, but doesnot require, an entity to use lower of cost or market for its inventory valuation. Lower ofcost or market is not permitted for LIFO inventory valuations, but is permitted for allother methods such as FIFO, average cost, etc. In comparing the new ASU 2015-11 tothe Code, there are a few key variations:

• ASU 2015-11 now uses lower of cost and net realizable value, while the Codecontinues to use lower of cost or market.

• The Code requires its lower of cost or market test be performed on an individ-ual-item basis, and not for the inventory in total, compared to ASU 2015-11 whichallows various approaches for the comparison.

In particular, Code Sec. 471.4 defines market as:

“the aggregate of the current bid prices prevailing at the date of the inventory. . . �

In applying the lower of cost or market method, the IRS regulations require that anentity:

“compare the market value of each item on hand on the inventory date withits cost and use the lower value as its inventory value . . . �

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Therefore, with the changes made by ASU 2015-11, there are certainly differences in theway in which lower of cost and net realizable value (for GAAP) and lower of cost ormarket (for tax purposes) are computed, thereby likely to result in book-tax differences,if material.

Application of Lower of Cost and Net Realizable Value to LIFO andthe Retail MethodAs previously noted, the FASB decided to exclude from the ASU’s scope, inventorymeasured using LIFO or the retail inventory method. As a result, the subsequentmeasurement guidance remains unchanged for inventory measured using these meth-ods. Those inventory methods continue to use the lower of cost or market approach.

The question is why didn’t the FASB extend the lower of cost and net realizablevalue measurement to LIFO and retail methods? The FASB notes that some third-partyusers had concerns about applying the ASU to LIFO and retail method for the followingreasons:

• The amendments would result in potentially significant costs, particularly upontransition, and would not simplify the subsequent measurement of inventory norresult in significantly more useful information for users of financial statements.

• The amendments also might not simplify the accounting for those entitiesbecause of the inherent complexities involved in estimating cost under LIFOand the retail inventory method and the related complexities involved in estimat-ing impairment.

• Under existing GAAP, inventory is not comparable across entities that usedifferent inventory methods. Therefore, the FASB concluded that making subse-quent measurement consistent across all methods would not improve compara-bility in any meaningful way.

• Some respondents did not want to eliminate the current use of replacement costin LIFO inventory valuations because they thought it was useful.

• Under the ASU, at the beginning of the year of adoption of the ASU, anyprevious write-downs from lower of cost or market are treated as part of theinventory cost. That means that if the new ASU rules were applied to LIFO, anyprevious write-downs would have to be allocated to LIFO layers to create theopening cost in the year the ASU is implemented. Such an allocation would addcomplexity to the LIFO valuation.

• Eliminating use of the existing floor (net realizable value less normal profit)would remove an existing practice used to value some retail inventories.

COMMENT: Under some approaches to applying the retail inventorymethod, the cost of inventory is estimated by multiplying the retail price ofinventory by a margin that excludes the effect of permanent markdowns, whichis similar to valuing inventory using net realizable value less normal profitmargin (commonly referred to as the “floor� in practice). The floor is one of themeasures that is eliminated by the ASU. Some users were concerned that thisapproach to applying the retail inventory method would no longer be permitted.

The changes the FASB originally proposed for inventory accounting applied toall companies, regardless of how they measured inventory. However, some largeretailers, including Target and Wal-Mart, complained that the proposal didn’ttake into account the nuances of calculating inventory under the LIFO or retailinventory methods. Thus, the FASB decided to exclude LIFO and the retailinventory methods from the scope of ASU 2015-11.

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Will ASU 2015-11 Achieve its Objectives?There are questions as to whether the ASU will actually simplify the existing lower ofcost or market model for inventory. On the positive side, advocates for the ASU’schanges suggest the following:

• For FIFO and average cost inventory, the ASU does in fact eliminate the three-outcome approach to determine market: replacement cost, net realizable value(ceiling) and net realizable value less normal profit (floor).

• The new model avoids having to determine a floor based on a normal profitmargin.

• The new model simplifies the test for a non-manufacturer who now only has tocompute net realizable value instead of a replacement cost and normal profit.

Critics, however, suggest the following as a result of the amendments from theASU:

• The ASU fails to change the model for LIFO and retail method inventorythereby providing two different approaches: one for FIFO and average cost,while another for LIFO and retail method.

• The split approach is not consistent with IFRS, which applies the net realizablevalue approach to all inventory.

• The model relies on net realizable value, which is based on sales in the normalcourse of business. There may be products that do not have active markets thatrequire unreliable estimates of sales.

• The new model places great reliance on selling price, which is subject to internalmanipulation and subjectivity, particularly if an item is sold within an inactivemarket.

¶206 DISCLOSURESASU 2015-11 and ASC 330 requires the following disclosures:

• Any losses from measuring inventory at lower of cost and net realizable value(for FIFO or average cost) or lower of cost or market (for LIFO and retailmethods) should be disclosed in the financial statements.

• An entity is required to disclose the nature of and reason for the change inaccounting principle in the first interim and annual period of adoption of ASU2015-11.

• An entity should continue to disclose the inventory valuation method in itssummary of significant accounting policies.

EXAMPLE: Assume an entity adopts the ASU for calendar year 2017. Thecompany uses the lower of cost and net realizable value which results in a write-down in the amount of $100,000 (no write-down in 2016). An example of thedisclosure is included below.

NOTE X: Inventory

Effective in 2017, the Company adopted Accounting Standards Update (ASU)2015-11, Inventory (Topic 330)-Simplifying the Measurement of Inventory to simplifythe measurement of its inventory. In accordance with ASU 2015-11, the Company isrequired to measure its inventory at the lower of cost and net realizable value. TheDecember 31, 2016 inventory was measured at the lower of cost or market and hasnot been re-measured to reflect the change made by ASU 2015-11.

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NOTE XX: Summary of Significant Accounting Policies

Inventory:

For the year 2017, the Company values its inventories at lower of cost and netrealizable value, using the first-in, first-out (FIFO) method. Net realizable value isdefined as the estimated selling prices of the inventory in the ordinary course ofbusiness, less reasonably predictable costs of completion, disposal and transporta-tion. For the year ended 2016, the Company valued its inventories at lower of costor market, using the FIFO method. In 2017, the company recorded a loss in theamount of $100,000 due to a write-down of its inventory to lower of cost and netrealizable value.

¶207 IMPLEMENTATION OF ASU 2015-11An entity is required to apply the amendments in the ASU prospectively to themeasurement of inventory after the date of adoption. Earlier application is permitted asof the beginning of an interim or annual reporting period.

If an entity has written down inventory below its cost before the adoption of theASU, and it was measured using any method other than LIFO or the retail inventorymethod, that reduced amount is considered the cost upon adoption. It is also importantto note that an entity is required only to disclose the nature of and reason for the changein accounting principle in the first interim and annual period of adoption.

EXAMPLE: Company X is a nonpublic entity that adopts ASU 2015-11 forcalendar year 2017. At December 31, 2016, the inventory was as follows:


Allowance – lower of cost or market (500,000)

Inventory- LCM $9,500,000

In the year of adoption (2017) any previous write-downs of inventory becomepart of the beginning inventory cost. In this example, Company X makes thefollowing entry on January 1, 2017 to reflect the inventory adjustment:

Allowance- lower of cost or market 500,000

Inventory 500,000

After the entry, the beginning inventory on January 1, 2017 is as follows:


Allowance – lower of cost or market ( 0)

Inventory- LCM $9,500,000

As a result, the previous write-down of $500,000 becomes part of the begin-ning cost.

At December 31, 2017, Company X values its inventory under ASU 2015-11 atlower of cost and net realizable value as follows:


Inventory at net realizable value 11,700,000

Allowance required for write-down $( 0)

There is no write-down entry in 2017 (first year of adoption of ASU 2015-11) asnet realizable value ($11,700,000) exceeds cost ($11,000,000).

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STUDY QUESTION

5. Which of the following is a reason why the FASB elected not to apply the ASU2015-11 amendments to entities that use the LIFO inventory valuation method?

a. The amendments would require an elimination of the LIFO reserve.

b. The amendments would provide a new requirement to use replacement cost.

c. The amendments would result in significant costs.

d. The amendments would provide a new requirement to use normal profit.

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29

MODULE 1: ONGOING ISSUES—CHAPTER3: Deferred Income Taxes and Net OperatingLosses¶301 WELCOMEThis chapter provides an overview of the accounting and reporting requirements withrespect to deferred income taxes and net operating losses. This includes a discussion ofvaluation accounts, future income considerations, as well as differences between varioustypes of carryforwards. This chapter also discusses the key requirements codifiedwithin ASC 740 from FIN 48 and certain changes prescribed by ASU 2015-17. Finally,the chapter concludes with a discussion related to corporate tax rates across differentcountries in the world.



• Identify the GAAP rules for measuring and recording a deferred tax asset andrelated valuation account

• Differentiate between both positive and negative evidence used to assess theappropriateness of a deferred tax asset valuation account

• Recognize and differentiate between the various types of carryforwards

• Identify key requirements codified within ASC 740 from FASB InterpretationNo. 48

• Recognize the key changes prescribed by ASU 2015-17

• Identify certain tax-planning strategies

• Differentiate between corporate tax rates across different countries in the world

¶303 ASC 740 – THE BASICSASC 740 is the GAAP authority for the accounting for income taxes. Total income taxesconsist of the current portion and the deferred portion. The current portion is recog-nized based on the estimated taxes payable or refundable on tax returns for the currentyear as a tax liability or asset. The deferred portion, on the other hand, is recognized asa deferred tax liability or asset for the estimated future tax effects attributable totemporary differences and carryforwards.

In addition, temporary differences are the difference between the book and taxbasis of an asset or liability that will result in taxable or deductible amounts in futureyears when the reported amount is recovered or settled. And finally, deferred tax assetsand liabilities are computed based on enacted tax rates expected to apply to taxableincome in the periods in which the deferred tax liability or asset is expected to besettled or realized. Refer to the following example for an overview of these overallprinciples.

EXAMPLE 1: Company X is a C corporation is a first year entity and has thefollowing M-1 reconciliation:

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Pretax book income $5,000,000

M-1:

Depreciation (1,000,000)

Taxable income 4,000,000

35%

Current federal income tax $1,400,000

Accumulated depreciation: 12-31-20X1:

Book $2,000,000

Tax 3,000,000

Temporary difference 1,000,000

Tax rate 35%

Deferred tax liability $350,000

Entry:

Income tax expense-current 1,400,000

Income tax expense-deferred 350,000

Accrued FIT 1,400,000

Deferred FIT 350,000

EXAMPLE 2: Company Z has the following information for year ended 2015:

2015 tax net operating loss $(1,000,000)

Temporary difference:

Accumulated depreciation at 12-31-15:

Book $2,000,000

Tax 3,500,000

Temporary difference $1,500,000

The $1 million 2015 net operating loss is available for carryforward to 2035 (20 years).The company had federal tax losses in the two carryback years (2013 and 2014) whichwere carried back to earlier years to obtain a federal tax refund. There is no portion ofthe 2015 NOL available for carryback. The temporary difference related to accumulateddepreciation (AD) will reverse in years 2016 through 2025. There are no other tempo-rary differences and no state income taxes.

A deferred income tax asset and liability was recorded with balances at 12-31-15 asfollows:

Deferred income tax asset (federal):

2013 federal tax net operating loss $1,000,000 x 35% $350,000

[NOL expires in 2035, 20 years]

Deferred income tax liability:

Temporary difference: AD $1,500,000 x 35% $(525,000)

Putting aside the political aspects of corporate tax rates, the question is, what happensto deferred income tax balances if corporate rates decline from 35 percent to 28percent? In February 2015, the Georgia Tech Financial Analysis Lab issued a studyentitled, The Effects of Tax Reform on Deferred Taxes: The Winners and Losers. In thestudy, the authors examined 809 U.S. companies and the impact of U.S. corporateincome tax reform on deferred taxes and which companies and industries will gain andlose if tax reform were to come to fruition. The focus of the study was to address the

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31MODULE 1 - CHAPTER 3 - Deferred Income Taxes and NOLs

adjustment, if any, which would occur to deferred tax assets and liabilities if tax rateswere to be reduced from 35 percent to 28 percent.

Deferred tax assets and liabilities are recorded at the marginal tax rate expected tobe in effect when the temporary differences that create the deferred taxes reverse infuture years. A change in the corporate rate to 28 percent would result in a reduction inboth deferred tax assets and liabilities, resulting in a change in assets, liabilities andstockholders’ equity in most companies. For a sample of 809 U.S. companies withrevenue greater than $500 million with reported deferred tax balances, the authors ofthe study present the financial statement effects of lowering the corporate income taxrate from 35 percent to 28 percent. The results of the study reveal the following:

• If rates were to decline from 35 percent to 28 percent, the 809 sampledcompanies would receive an overall net increase in stockholders’ equity of $104billion broken out as follows:

- 548 of the companies sampled with deferred tax liabilities would receive a $142billion reduction in liabilities and increase in stockholders’ equity. In addition,liabilities would decline by 2 percent, stockholders’ equity would increase by 3.3percent, and financial leverage (liabilities to equity ratio) would decline by 5.5percent.

- 261 of the companies would see a decline of $38 billion in deferred tax assetsand decrease in stockholders’ equity. In addition, assets would decline by .4percent, stockholders’ equity would decrease by 1.2 percent, and financialleverage would increase by 1.2 percent.

• Winners would include utilities and energy sectors, electric, gas and waterutilities, oil and gas exploration, and transportation, including railroadcompanies.

• Losers would include the following:

- Mortgage, finance and banking sectors

- Financial companies

- Commercial banks

- Consumer finance companies

- Leisure equipment

- Durables

- Pharmaceuticals

- Biotechnology

- Auto components

- Computer hardware and software

• Companies that are net losers from tax reform (e.g., deferred tax assets andstockholders’ equity would decline) could violate existing loan covenants.

• Entities with the largest reduction in liabilities (winners) include the following:Biggest Winners from Reduction in Corporate Rates to 28%

Reduction in deferred % reduction in total Increase inCompany tax liabilities liabilities stockholders’ equity

Comcast $(6.3) billion (5.9)% 12.5%

Time Warner (2.3) billion (5.7)% 33.9%

Hilton International (967) million (4.4)% 22.2%

Hertz (584) million (2.7)% 21.1%

N star (303) million (6.8)% 12.2%

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Biggest Winners from Reduction in Corporate Rates to 28%

Reduction in deferred % reduction in total Increase inCompany tax liabilities liabilities stockholders’ equity

Median- all sampled (2.0)% 3.3%

Source: Georgia Tech Financial Analysis Lab study, The Effects of Tax Reform on DeferredTaxes: The Winners and Losers.

Biggest Losers from Reduction in Corporate Rates to 28%

Reduction in deferredtax % reduction in Decrease in

Company Assets total assets stockholders’ equity

Fannie Mae $9.5 billion (.3)% (99.7)%

Orbitz 32 million (2.9)% (77)%

Federal Home Loan 4.5 billion (.2)% (35.4)%Mtg

Delta 1.3 billion (2.6)% (11.6)%

Citigroup 10.6 billion (.6)% (5.2)%

Median all sampled (.4)% (1.2)%

Source: Georgia Tech Financial Analysis Lab study, The Effects of Tax Reform on DeferredTaxes: The Winners and Losers.

So if the corporate tax rate were to decline from 35 percent to 28 percent, where wouldthe adjustment of the deferred tax asset or liability be presented on financialstatements?

ASC 740-10-45-15 states “when deferred tax accounts are adjusted as required byparagraph 740-10-35-4 for the effect of a change in tax laws or rates, the effect shall beincluded in income from continuing operations for the period that includes the enact-ment date.� Therefore, if the corporate tax rate is reduced to 28 percent, the deferredtax asset and/or liability would be adjusted to the lower rate with the offsetting entry toincome tax expense. Consider the following example:

Company Z has the following information for year ended 2016:




Book $2,000,000

Tax 3,500,000


The $1 million 2016 net operating loss is available for carryforward to 2036 (20 years).The temporary difference related to accumulated depreciation (AD) will reverse inyears 2017 through 2026. There are no other temporary differences and no state incometaxes. A deferred income tax asset and liability was recorded with balances at 12-31-16as follows:






Effective January 1, 2017, the U.S. corporate tax rate is reduced from 35 percent to 28percent. As a result, effective January 1, 2017, the deferred tax asset and liability arerecomputed at the new 28 percent rate as follows:

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Deferred tax asset:

Originally computed: 1,000,000 × 35% $350,000

Revised 1,000,000 × 28% 280,000

Adjustment $70,000

Originallycomputed Revised

Deferred tax liability: 35% 28%



Book $2,000,000 $2,000,000

Tax 3,500,000 3,500,000

Temporary difference 1,500,000 1,500,000

35% 28%

$525,000 $420,000

Adjustment $105,000

Entry: (January 1, 2017)

Deferred tax liability 105,000

Deferred tax asset 70,000

Income tax expense- deferred (1) 35,000

(1) shown as a separate component of income tax expense

In 2017, the $35,000 deferred tax adjustment is shown as a separate component ofincome tax expense as follows:

NOTE X: Income Taxes:

A summary of the current and deferred portions of federal income tax expensefollows:

Current portion $XX

Deferred XX

Adjustment due to change in tax rates (35,000)

Total income tax expense XX

If there is a valuation allowance account, it too should be adjusted to reflect thereduction in the federal marginal tax rate with the offset to income tax expense as partof continued operations.

¶304 DEFERRED INCOME TAX ASSETS FROM NOLSASC 740 requires a company to record a deferred income tax asset for the tax benefit ofa net operating loss (NOL) carryforward. The asset represents the tax benefit that willbe received when the company ultimately uses that NOL in future years. In order toactually use the NOL, the company must have future income to absorb that NOL. Underexisting federal tax law, a company can carry back an NOL two years, and then carryforward the unused NOL for 20 years. Of course, a company can elect to foregocarryback of the NOL and instead carry forward the NOL. The following exampleillustrates how these rules are applied in practice:

Company X generates a federal income tax loss in 20X5 in the amount of $500,000. Thecompany carries back $200,000 of the $500,000 to years 20X3 and 20X4 by filing a Form1139 and obtains a refund from the IRS. The remaining $300,000 NOL is carried forwardto years 20X6 and beyond and can be used through year 20X25. For simplicity, assume

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there are no surtax rates and that the federal tax rate is 35 percent. The entry in 20X5follows:

dr cr

IRS refund receivable (1) 70,000

Income tax expense- current federal 70,000

Deferred income tax asset (2) 105,000

Income tax expense-deferred federal 105,000

(1): NOL carryback: $200,000 x 35% = $70,000.

(2): Unused NOL carryforward: $300,000 x 35% = $105,000.

Now, the IRS refund of $70,000 will be received by the company. As to the deferredincome tax asset, the tax benefit of $105,000 will be received only if and when thecompany has future federal taxable income of $300,000 to utilize the NOL carryforward.In addition, the company has 20 years in which to generate a total of $300,000 of futuretaxable income to use the NOL. In many cases, an active going concern entity will haveno problem using the NOL so that the full deferred income tax asset of $105,000 will beutilized within the 20 year time frame.

In addition, ASC 740 requires a company to recognize a valuation account against adeferred income tax asset if based on the weight of available evidence; it is more likelythan not (more than 50-percent probability) that some portion or all of the deferred taxasset will not be realized. The valuation allowance should be sufficient to reduce thedeferred tax asset to the amount that is more likely than not to be realized. In order todetermine the amount of the valuation account, the entity should determine whether itwill have enough future taxable income during the NOL carryforward period to use theunused NOL. If the answer is “yes,� there is no need for a valuation account. However, ifthe answer is “no,� a valuation account must be established for a portion or the entiredeferred tax asset.

When determining whether there is enough future income to which the NOL canbe applied, an entity can take into account income from all of the following sources:

• Reversal of existing taxable temporary differences into taxable income assumingtaxable income is zero

• Estimated future taxable income (exclusive of reversing temporary differencesand carryforwards)

• Taxable income in prior carryback year(s) if carryback is permitted under thetax law, and

• Tax-planning strategies that the company would, if necessary, implement toutilize an expiring NOL such as:

- Accelerate taxable amounts to utilize expiring carryforwards

- Change the character of taxable or deductible amounts from ordinary incomeor loss to capital gain or loss

- Switch from tax-exempt to taxable investments

While there are several sources of future income, in most cases involving a deferredincome tax asset, future taxable income comes from either estimated future taxableincome during the 20-year carryforward period and taxable temporary differences thatwill reverse into taxable income during the 20-year carryforward period as evidenced bythe existence of deferred income tax liabilities. Additionally, in most cases, if a companyhas deferred income tax liabilities equal to or in excess of the deferred income tax assetrelated to the NOL, that fact, in and of itself, means the company will have enoughfuture income to utilize the NOL.

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ASC 740, Income Taxes does give a list of factors that should be considered indetermining whether there will be sufficient future taxable income during the NOLcarryforward period to utilize the deferred income tax asset. These are summarized inthe following table:

Evidence Used To Determine Whether A Valuation Account Is Needed

Negative Evidence Leading to a Conclusion that Valuation Positive Evidence Leading to a Conclusion that aAccount is Needed Valuation Account is Not Needed

• Cumulative losses in recent years • Existing contracts or firm sales backlog(usually the last three years including that will produce more than enoughthe current year) taxable income to realize the deferred

tax asset based on existing sales pricesand cost structures

• History of operating loss or tax credit • An excess of appreciated asset valuecarryforwards expiring unused over the tax basis of the entity’s net

assets in an amount sufficient to realizethe deferred tax asset

• Losses expected in early future years (by • A strong earnings history, exclusive ofa presently profitable entity) the loss that created the future

deductible amount (tax losscarryforward or deductible temporarydifference), coupled with evidenceindicating that the loss (e.g., an unusual,infrequent, or extraordinary item) is anaberration rather than a continuingcondition

• Unsettled circumstances that, ifunfavorably resolved, would adverselyaffect future operations and profit levelson a continuing basis in future years

• A carryback or carryforward period thatis so brief that it would limit realizationof tax benefits if (1) a significantdeductible temporary difference isexpected to reverse in a single year, or(2) the enterprise operates in atraditionally cyclical business

Negative evidence, by itself, makes it difficult to reach a conclusion that a valuation isnot needed. However, the existence of positive evidence might support a conclusionthat a valuation allowance is not needed when there is negative evidence. In particular,ASC 740 notes that “forming a conclusion that a valuation allowance is not needed isdifficult when there is negative evidence such as cumulative losses in recent years.�

Following are a few examples that illustrate the guidance presented above:

Company X has the following information for year ended 2015:




Book $2,000,000

Tax 3,500,000


The $1 million 2015 net operating loss is available for carryforward to 2035 (20 years).The company had federal tax losses in the two carryback years (2013 and 2014) whichwere carried back to obtain a federal tax refund. As such, there is no portion of the 2015

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NOL available for carryback. The temporary difference related to accumulated deprecia-tion will reverse in years 2016 through 2025 and there are no other temporary differ-ences and no state income taxes.

A deferred income tax asset and liability were recorded with balances at 12-31-15 asfollows:






Should the company record a valuation account related to the $350,000 deferred incometax asset?

ASC 740 requires a company to recognize a valuation account against a deferredincome tax asset if it is more likely than not (more than 50-percent probability) thatsome portion or the entire deferred tax asset will not be realized. In making theassessment, the Company must consider whether there will be enough future taxableincome during the 20-year NOL carryforward period to utilize the $1 million NOL and$350,000 deferred tax asset.

One of the sources of future taxable income is if there are existing taxabletemporary differences that will reverse into taxable income during the 20-year carryfor-ward period. In this example, the company already knows that it has $1.5 million offuture taxable income from reversal of the accumulated depreciation temporary differ-ence. That reversal will occur in years 2016 through 2025 which is within the NOLcarryforward period.

Because the company has a taxable temporary difference ($1.5 million) in excess of$1 million that will reverse in the NOL carryforward period, the deferred tax asset of$350,000 will be realized. As a result, no valuation account is required.

COMMENT: The easiest source of future taxable income is where a companyhas a deferred tax liability from a temporary difference that will result in futuretaxable income during the NOL carryforward period. This source of future taxableincome does not require any forecasts because it is based on events that havealready occurred.

Company X has the following information for year ended 2015:

2015 net operating loss- tax purposes $(1,000,000)



Book $2,000,000

Tax 2,600,000

Temporary difference $ 600,000

The $1 million 2015 net operating loss is available for carryforward to 2035 (20 years).

The company had federal tax losses in the two carryback years (2013 and 2014)which were carried back to earlier years to obtain a federal tax refund. The companyalso had a tax loss in 2012. There is no portion of the 2015 available for carryback. Thecompany also had pretax book losses in years 2012 through 2014 with no signs ofimprovement for 2015 and beyond. The temporary difference related to accumulateddepreciation ($600,000) will reverse in years 2016 through 2025 and there are no othertemporary differences and no state income taxes.

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A deferred income tax asset and liability was recorded with balances at 12-31-15 asfollows:Deferred income tax asset (federal):




Temp difference: AD $600,000 x 35% $(210,000)

The company can use the future taxable temporary difference of $600,000 as a source offuture income that will utilize the $1 million NOL carryforward. However, there appearsto be no other sources of future income that can be justified. In particular, the companyhas had a series of book losses in 2012 through 2014. ASC 740 states that “forming aconclusion that a valuation allowance is not needed is difficult when there is negativeevidence such as cumulative losses in recent years.� Given the fact that there is nopositive evidence to support future taxable income beyond the $600,000 of futuretaxable income from the reversal of the temporary differences, a valuation account isrequired as follows:Deferred income tax asset (federal): $1,000,000 x 35% $350,000

Future income:

Deferred income tax liability reversal: $600,000 x 35% (210,000)

Valuation allowance required: $400,000 x 35% $(140,000)

Entry:

Income tax expense- deferred federal 140,000

Valuation allowance 140,000

Balance sheet presentation:Assets:

Deferred income tax asset *$210,000

Long-term Liabilities:

Deferred income tax liability **(210,000)

* DIT asset of $350,000 less valuation of $140,000 = $210,000.

** DIT liability related to accumulated depreciation temporary difference.

COMMENT: In using existing taxable temporary differences (deferred in-come tax liabilities) to justify future taxable income to utilize a deferred income taxasset from an NOL carryforward, the analysis is done based on the assumption thatthere is no other taxable income or loss during the years in which the taxabletemporary differences reverse. The taxable temporary difference is scheduledwithout regard to any other taxable income or loss. In Example 1, the analysisindicates that there is $1.5 million of future taxable income that the company willhave when the accumulated depreciation reverses in future years. Notice that theanalysis assumes that taxable income in those future years is zero and that the onlytaxable income in those future years is the reversal of the taxable temporarydifference of $1,5 million.

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STUDY QUESTIONS

1. In accordance with ASC 740, a company is required to record a valuation accountagainst a deferred income tax asset if it is _____________ that some portion of or theentire deferred tax asset will not be realized.

a. Probable

b. Reasonably possible

c. More likely than not

d. Highly likely

2. With respect to deferred tax assets, in accordance with ASC 740, future income cancome from which of the following?

a. Estimated future taxable income, including the reversal of temporary differ-ences and carryforwards

b. Switching from tax-exempt to taxable investments as part of a tax-planningstrategy

c. Reversal of existing taxable temporary differences assuming taxable include isgreater than book income

d. Current year tax losses

3. Which of the following identifies an impact of lowering the corporate tax rate?

a. Deferred tax assets would be adjusted downward.

b. Deferred tax assets would be adjusted upward.

c. There would be no effect on deferred tax assets, but there is an impact on theaccrued federal tax liability.

d. A larger valuation account would be required for deferred tax assets.

¶305 BALANCE SHEET PRESENTATIONASC 740 requires that deferred tax liabilities and assets be classified on the balancesheet as current or noncurrent based on the classification of the related asset or liabilityfor financial reporting. A deferred tax liability or asset that is not related to an asset orliability for financial reporting, including deferred tax assets related to NOL carryfor-wards, shall be classified according to the expected reversal date of the temporarydifference.

In the previous example, the $210,000 deferred income tax asset (net of thevaluation), does not relate to an underlying asset or liability that created a temporarydifference. Therefore, the deferred tax asset is split on the balance between current andlong-term based on the estimated reversal date of the asset. That portion of the assetthat is expected to reverse based on future taxable income occurring within one year ispresented current, while the remainder of the deferred tax asset is presented long-term.As for the liability, because it related to a long-term asset (accumulated depreciation),the resulting deferred tax liability is presented as a long-term liability.

COMMENT: There are certain states that allow net operating losses to becarried forward indefinitely. If this is the case, a deferred income tax liabilityrelated to an indefinite lived asset (such as goodwill) can be used as a source ofincome that can support the realization of the deferred tax asset. The reason isbecause the temporary difference from the indefinite lived asset has no deadline toreverse into taxable income. When the temporary difference reverses from an

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ultimate sale or impairment writedown, that taxable income will utilize the NOLgiven the fact that the state NOL has an unlimited carryforward period.

COMMENT: In November 2015, the FASB issued ASU 2015-17, Income Taxes(Topic 740): Balance Sheet Classification of Deferred Taxes. The ASU amends ASC740 to provide that deferred income tax assets and liabilities should be presentedas noncurrent on the balance sheet instead of being presented as current or long-term based on the classification of the underlying temporary difference. The FASBmade this change as part of its Simplification Initiative. For public entities, the ASUis effective for financial statements issued for annual periods beginning afterDecember 15, 2016, and interim periods within those annual periods. For all otherentities, (including nonpublic entities) the amendments in this Update are effectivefor financial statements issued for annual periods beginning after December 15,2017, and interim periods within annual periods beginning after December 15,2018.

¶306 FUTURE INCOMEPreviously, we addressed the situation in which future taxable temporary differences,such as those related to accumulated depreciation, are an easy source of future incomethat would absorb a deferred income tax asset. Now let’s assume there are no deferredtax liabilities related to future taxable temporary differences. Therefore, the only way toavoid having to record a valuation allowance is to estimate future taxable income(exclusive of reversing temporary differences) that the company will generate duringthe 20-year NOL carryforward period.

In concept, such an exercise should yield plenty of taxable income. After all, acompany has 20 years of estimated taxable income to use the NOL carryforward.Although it is true that estimating enough future taxable income over a 20-year periodthat is sufficient to use an unused NOL carryforward should be easy, it may beimpossible to do under the “cumulative loss� rule. Previously, it was noted that inassessing whether a valuation allowance is needed, both positive and negative evidencemust be considered. If it is more likely than not, based on the evidence, that thedeferred tax asset will not be realized by future taxable income, a valuation is requiredfor any shortfall. ASC 740 states that cumulative losses in recent years is a negativefactor that may be difficult to overcome with other positive factors.

The question is, how many years of cumulative losses create a pattern of negativeevidence that is so great that one cannot estimate that future taxable income will existand therefore a valuation account is required?

In Appendix A to ASC 740, the FASB was quite careful not to create a bright-linetest as it relates to cumulative losses. Although many companies and their accountantsuse three years of losses (current year and two prior years) to define the term“cumulative losses,� such an approach is non-authoritative but has become generallyaccepted. ASC 740 does not give any guidance as to how to determine cumulative lossesand the number of years of losses that would suggest a negative trend.

Although not authoritative, many CPA firms and their clients are using a “soft� three-year period (current year and two prior years) to assess whether there are cumulativelosses, based on the following structure:

• “Cumulative losses� is based on the last three years of pre-tax book income(losses) consisting of the current year and two prior years.

• Pre-tax GAAP income is used instead of taxable income.

COMMENT: Because the FASB places so much weight on the cumulativelosses as a component of negative evidence, companies should be careful not tofall into the trap of doing a mechanical three-year computation of pre-tax GAAP

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losses to define cumulative losses. What is more important is the direction inwhich the losses are headed and whether there are any non-recurring transac-tions that might distort the real upward or downward trend.

At December 31, 20X3, Company X has a deferred tax asset in the amount of $1 milliondue to an unused NOL carryforward. The company also has no deferred tax liabilities.

Pre-tax book income is:Year

20X3 (current year) $(2,000,000)

20X2 (1,200,000)

20X1 (500,000)

$(3,700,000)

Cumulative losses total $3.7 million over the most recent three-year period and thetrend appears to be leading toward greater losses in the most recent year 20X3. The factthat there are cumulative losses is strong negative evidence that it is more likely thannot that the company will not have sufficient future taxable income to utilize the $1million deferred income tax asset during the NOL carryforward period. That is, thecompany cannot estimate future taxable income will exist. As a result, it is highlyunlikely that X can gather sufficient positive evidence to override the cumulative losses’negative evidence. Consequently, X should record a $1 million valuation allowance tooffset the $1 million deferred income tax asset as illustrated below.Entry: dr cr

Income tax expense- deferred federal 1,000,000

Valuation allowance 1,000,000

Previously, we saw that one way to determine future taxable income is to look todeferred income tax liabilities that will reverse into income during the NOL carryfor-ward period. Clearly, having deferred income tax liabilities that equal or exceed thedeferred income tax asset is the easiest and most verifiable way to prove future incomebecause it is based on transactions that have already occurred; that is, the deferred taxliability has already been measured and the timing and amount of its reversal arequantifiable.

When there is not a sufficient amount of deferred income tax liability to use thedeferred income tax asset, the company should look to other sources of future taxableincome. This step involves estimating the amount of taxable income the company willhave during the NOL carryforward period without regard to any taxable income thatwould be created from the reversal of existing deferred income tax liabilities. Estimat-ing future taxable income is difficult as it requires use of forecasted information which isimperfect at best. Moreover, if the company has cumulative losses (assume over thepast three years including the current year), it is generally assumed that the companywill not have future taxable income and a valuation allowance will be required for theentire amount of the deferred tax asset. Refer to the example below for an illustration ofthis topic.

Let’s assume that the company has no deferred tax liabilities that will reverse intotaxable income. Let’s further assume that there is no negative evidence of cumulativelosses. That is, the deferred tax asset was created because a significant tax loss in thecurrent year due to a sizeable M-1 tax deduction.

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Pre-tax book income is:Year

2014 (current year) $(200,000)

2013 100,000

2012 50,000

At December 31, 2014, the Company had an unused federal tax NOL carryforward of$230,000.

The 2014 book loss was a direct result of additional depreciation from 2014 fixedasset additions. The company uses the same book and tax depreciation. Historically, thecompany has had taxable income in the $50,000 to $100,000 range depending on theamount of officer bonuses taken each year. At December 31, 2014, the company has avery strong sales backlog for the next three to five years and there are no temporarydifferences or state income taxes.

A deferred income tax asset was recorded at 12-31-14 as follows:Deferred income tax asset (federal):

2014 federal tax net operating loss $230,000 x 34% $78,200


The company is required to record a valuation allowance against the $78,200 deferredtax asset to the extent that it is more likely than not that a portion of all of the deferredtax asset will not be realized from future taxable income during the 20-year NOLcarryforward period. In order to avoid having to record a valuation allowance, thecompany must justify that the company will have future taxable income from 2015 to2034 (20 years) of at least $230,000. If so, the NOL carryforward of $230,000 will beutilized. As for sources of future taxable income, the company has no deferred taxliabilities that will reverse into future taxable income. Thus, the company shouldestimate future taxable income.

In this case, the company should look at the positive and negative evidence inassessing whether there will be future taxable income. Evidence to consider in estimat-ing future taxable income includes the following:

• The company has had a strong earnings history (exclusive of the loss) in theannual amount of $50,000 to $100,000 of taxable income.

• 2012 book loss of $(200,000) as an aberration based on the existence of a non-recurring amount of depreciation. ASC 740 specifically states that in estimatingfuture taxable income, a company should consider the existence of evidenceindicating that the loss is an aberration rather than a continuing condition.Clearly, the 2014 loss is an aberration.

• There is no evidence of cumulative pre-tax book losses over the past three yearsincluding 2012.

• The company has a strong sales backlog that will produce sufficient taxableincome over the next three to five years.

Based on a weight of the positive and negative evidence, the company should estimatefuture taxable income for years 2034 as follows:

Estimated annual federal taxable income $50,000

# years in NOL carryforward period x 20

Estimated future taxable income $1,000,000

Unused NOL carryforward from 2014 $(230,000)

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The company estimates that there will be $1 million of future taxable incomegenerated during the NOL carryforward period, which is sufficient to utilize the entire$(230,000) of net operating loss. The result is that there is no need to record a valuationallowance.

Tax-Planning StrategiesTax-planning strategies consist of actions (including elections for tax purposes) that:

• Are prudent and feasible with management having the ability to implement thestrategy

• An enterprise ordinarily might not take, but would take to prevent an operatingloss or tax credit carryforward from expiring unused, and

• Would result in realization of deferred tax assets.

Examples of tax-planning strategies include a plan to do any of the following:

• Accelerate taxable amounts to use expiring NOLs:

- Selling appreciated assets and inventory, including inventory that would triggera recapture of the LIFO reserve

- Selling investments including available-for-sale securities

- Electing out of the installment sales method to accelerate taxable income on asale

- Changing the tax status

- Making an election to change a tax accounting method that triggers taxableincome

• Change the character of items from ordinary income to capital gain (loss)

• Switch from tax-exempt to taxable investments

COMMENT: Tax-planning strategies are a way of life for all taxpayers,corporate and individual, alike. Inherent in the use of a tax-planning strategy isthe goal to make sure that an NOL carryforward does not expire unused. ASC740 requires that a company consider the use of tax-planning strategies indetermining the need for a valuation allowance; that is, in estimating futuretaxable income.

Deferred Tax Asset on Carryforwards other than NOLs?While ASC 740 requires that a deferred tax asset be recorded for the tax benefit of anNOL carryforward, what about other types of carryforwards that reflect a future taxbenefit such as unused charitable contributions carryforward, Section 179 deductioncarryforward, and capital loss carryforward? The listing below provides an overview ofeach of the previously mentioned other carryforwards.

• Charitable contributions:

- Can be carried over for five years for that portion that exceeds 10 percent oftaxable income (without regard to the deduction for the contribution and otheritems).

• Section 179 deduction:

- Is limited to taxable income with the unused portion carried forwardindefinitely.

• Capital loss carryover:

- Any unused capital loss is carried forward for five years from the loss year.

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The overall principle is that a deferred tax asset should be recorded on “carryfor-wards� without regard to the types of carryforwards. In theory, each carryforward mayprovide a future tax benefit that should be captured by recording the deferred tax asset.However, as an additional point of emphasis, a valuation account should be recorded tothe extent that it is more likely than not that carryforward will not be realized during thecarryforward period. Moreover, materiality should be considered. For example, is theamount of an unused charitable contribution material?

Company X is a C corporation and has the following at December 31, 20X1:Expiration date Amount

Unused Federal NOL carryforward 20 years $(1,000,000)

Unused Charitable contributions carryfoward 5 years (50,000)

Unused Section 179 deduction carryforward Unlimited (100,000)

Unused Capital loss carryforward 5 years (150,000)

Totals $(1,300,000)

Assume the following information:

• There is a federal tax rate of 34 percent in future years with no surtax rates andno state taxes.

• X expects to have future taxable income of $200,000 per year, and the $1 millionNOL was based on a non-recurring transaction.

• There is no DIT asset on the balance sheet.

• The company has a tax-planning strategy under which it will not allow thecapital loss carryforward to expire. That is, it will sell a capital asset andgenerate a capital gain within the five-year period.

Conclusion

X should record a deferred tax asset as follows:

Combined carryfowards ($1,300,000)

Tax rate 34%

DIT asset $442,000

Entry: dr cr

Deferred income tax asset-federal 442,000

Income tax expense- federal deferred 442,000

Based on the assumption of future taxable income of $200,000 per year, all carryfor-wards should be utilized during their respective carryforward periods except the capitalloss carryforward. However, the company has a tax-planning strategy that will result in acapital gain being created within the five-year carryforward period. Thus, the capital losscarryforward will be utilized and a valuation account is not required.

COMMENT: Obviously, materiality must be considered in deciding whetherto record a deferred tax asset on a carryforward. For example, a small amount ofunused contributions may not warrant a deferred tax asset. Conversely, a largeamount of unused Section 179 depreciation may require a deferred tax asset.

Presentation of Tax Benefit of NOL CarryforwardOne of the key questions to ask is how the use of a net operating loss carryover shouldbe presented on the income statement. ASC 740 requires the tax benefit of the NOL to

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be presented as a direct reduction in the current portion of income tax expense with acorresponding disclosure. The following example illustrates the application of thisguidance.

A company has a $(300,000) NOL carryforward in 20X1 and records a deferredincome tax asset as follows:Entry: 20X1 dr cr

DIT asset ($300,000 x 34%) 102,000

Income tax expense- deferred 102,000

The $300,000 unused NOL is carried over from 20X1 to 20X2. Also assume the following20X2 information:

Taxable income before NOL $800,000

NOL carryforward utilized (300,000)

Taxable income 500,000

Tax rate 34%

Current FIT provision $170,000

As a result, the December 31, 20X2 entry consists of two components:• Current accrual provision of $170,000• Reversal of the $102,000 deferred income tax asset that is used in 20X2.

Entry: 20X2 dr cr

Income tax expense- current provision 170,000

Accrued FIT 170,000

Income tax expense-deferred 102,000

Deferred income tax asset 102,000

The total federal income tax expense in 20X2 looks like this:Current provision (net of NOL) $170,000

Deferred 102,000

Total provision (FIT expense) $272,000

Presentation on the statement of income:

Net income before income taxes $XX

Income tax expense 272,000

Net income $XX

The provision for income includes federal taxes currently payable and deferred incometaxes arising from assets and liabilities whose basis is different for financial reportingand income tax purposes. The majority of the deferred tax provision is the result ofbasis differences in recording depreciation and accruing certain expenses. The provi-sion for income taxes is summarized as follows:

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Federal:

Currently payable $ 272,000 (1)

Deferred 102,000

Reduction due to use of net operating

loss carryforward (102,000) (2)

Total federal provision 272,000

State:

Currently payable xx

Deferred xx

Total state provision xx

Total provision xx

(1) 800,000 x 34% = 272,000

(2) 300,000 x 34% = (102,000)

Net current provision 170,000

Tax Rate to use for DITs when there are Surtax RatesASC 740-10-30-8 states that a deferred tax liability or asset is recorded using the enactedtax rate(s) expected to apply to taxable income in the periods in which the deferred taxliability or asset is expected to be settled or realized. Furthermore, in situations inwhich graduated (marginal) tax rates are a “significant factor,� ASC 740-10-30-9 statesthat the deferred liability or asset shall be measured using the average graduated taxrate applicable to the amount of estimated annual taxable income in the periods inwhich the deferred tax liability or asset is expected to be settled or realized. Thus, theaverage graduated tax rate should be used based on the level of taxable income(including reversal of the temporary difference) in the reversal years.

Consider the following table as an example:Average

Cumulative Marginal tax Cumulative graduated taxTaxable income taxable income rate on Tax rate

increment (B) increment Marginal tax (A) (A)/(B)

$50,000 $50,000 15% $7,500 $7,500 15%

25,000 75,000 25% 6,250 13,750 18%

25,000 100,000 34% 8,500 22,250 22%

100,000 200,000 39% 39,000 61,250 31%

100,000 300,000 39% 39,000 100,250 33%

35,000 335,000 39% 13,650 113,900 34%

65,000 400,000 34% 22,100 136,000 34%

100,000 500,000 34% 34,000 170,000 34%

9,500,000 10,000,000 34% 3,230,000 3,400,000 34%

>$10,000,000 35% 35%

EXAMPLE: Company X has a temporary difference related to accumulateddepreciation in the amount of $40,000 that will reverse evenly over the next 10years. Assume that X estimates that its taxable income, including the reversal ofthe temporary difference, will be approximately $100,000 in each of the 10 reversalyears.

Because estimated taxable income in the 10 reversal years will be approximately$100,000, the graduated tax rates range from 15 percent to 34 percent and those rateswill be significant. Therefore, GAAP requires that average graduated tax rates for the

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estimated amount of taxable income (including the reversal of the temporary differ-ence) should be used to record the deferred income tax liability. The average graduatedincome tax rate on $100,000 of taxable income is 22 percent.

The deferred tax liability should be recorded as follows:Temporary difference $40,000

Average graduated tax rate 22%

Deferred tax liability $8,800

Problems on the Uncertain Tax Positions FrontThe rules for recording uncertain tax benefit liabilities under FASB Interpretation 48(FIN 48) have been around since 2006. Yet, these rules continue to be controversial andreach far beyond the financial statements. The purpose of this section is to addresssome of the current developments related to FIN 48 including:

• Clarification of the disclosures related to nonpublic entities• Impact that FIN 48 liabilities have on SEC companies• Roadmap that FIN 48 liabilities are providing to the IRS

The rules for uncertain tax positions were issued approximately one decade ago in FIN48, which is now part of ASC 740. Although the rules for uncertain tax positions may notbe applicable to many smaller, nonpublic entities, there have been questions as towhether nonpublic entities are required to include certain FIN 48 disclosures if an entityhas no uncertain tax positions.

The authority for tax positions is found in ASC 740 which provides guidance on thetreatment of derecognition, classification, interest and penalties, accounting in interimperiods, disclosures and transition, as they relate to tax positions. The rules apply to alltax positions accounted for under ASC 740.

A tax position results in:• A permanent reduction in income taxes payable,• A deferral of income taxes otherwise currently payable to future years, or• A change in the expected realizability of deferred tax assets.

The rules found in ASC 740 apply as follows:• If it is more likely than not (more than 50-percent probability) that a tax position

will be sustained upon IRS or state tax examination (including any appeals orlitigation process), the amount of the tax effect of a tax position is retained onthe financial statements.

• If it is not more likely than not (not more than 50-percent probability) that thetax position will be sustained upon an IRS or state tax examination, all of the taxeffect of the tax position is eliminated in the financial statements by recording aliability for the hypothetical additional tax that will be paid when the tax positionis disallowed upon IRS or state examination.

The rules for uncertain tax positions apply to federal, state and local and foreign incometaxes, but do not apply to sales and use taxes, franchise taxes, real estate and personalproperty taxes, and fees that are not taxes. Moreover, it is assumed that a company goesthrough an IRS or state tax examination, including, if applicable, appeals.

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EXAMPLE: Tax Deduction:

Company X computes its 20X7 tax provision as follows:Taxable Tax TaxIncome rate (Fed/state)

Net sales $1,000,000

Operating expenses:

Travel (2,500)

All other (597,500)

Total operating expenses (600,000)

NIBT 400,000 40% 160,000

M-1: Depreciation (50,000) 40% (20,000)

Taxable income $350,000 40% $140,000

Entry:

Income tax expense 160,000

Deferred income tax liability 20,000

Accrued tax liability 140,000

Company X takes a $2,500 tax deduction for certain items that may be nondeductibletravel related to a shareholder’s spouse. The tax benefit of the item embedded withinthe tax provision is $1,000 ($2,500 x 40%). X believes that if it were audited by the IRSand Massachusetts Department of Revenue, it is more likely than not (more than50-percent probability) that the entire deduction is sustainable even if X has to go toappeals or even tax court.

As a result, X would retain the tax benefit of the tax deduction on its financialstatements. That means that X would not record an additional liability for the additionaltax that would be paid if the deduction were disallowed upon examination.

However, what if X believes that upon examination, the entire $2,500 deductionwould be disallowed? In this case, it is not more likely than not that the $2,500deduction would be sustained, resulting in an additional tax in the amount of $1,000, forwhich an additional liability is recorded as follows:

The revised entry looks like this:Revised Entry:

Income tax expense 161,000*

Deferred income tax liability 20,000

Accrued tax liability 140,000

Liability for unrecognized tax benefit 1,000

* Book income ($400,000) plus unrecognized deduction ($2,500) = $402,500 x 40% = $161,000.

FIN 48 applies to all entities including:• For-profit entities• Not-for-profit entities• Pass-through entities (S corporations, LLCs, and partnerships)• Entities taxed in a manner similar to pass-through entities such as REITs and

registered investment companies (Entities whose liability is subject to 100percent credit for dividends paid (REITs and registered investmentcompanies)).

COMMENT: Not-for-profit, pass-through entities, and tax-exempt organiza-tions are subject to FIN 48 because they can pay taxes in certain situations. For

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example, an S corporation can be subject to a built-in-gains tax under InternalRevenue Code (Code) Sec. 1374. Similarly, a not-for-profit entity can be subjectto a tax on unrelated business income.

A reporting entity must consider the tax positions of all entities within a related-partygroup of entities regardless of the tax status of the reporting entity. ASU 2009-06amended FIN 48 to include under the definition of a tax position an entity’s tax statussuch as an entity’s status as a pass-through entity (S corporation) or a tax-exempt not-for-profit entity. For example, one such tax position is the company’s position that it isproperly in compliance with the Code to be taxed as an S corporation, or it is an LLCthat is taxed as a partnership instead of a corporation.

STUDY QUESTIONS

4. Under existing GAAP per ASC 740, how should a deferred tax liability be classifiedon the balance sheet?

a. Always shown as current and long-term based on the estimated reversal dateb. Current and long-term based on the classification of the related asset or

liabilityc. Always long-termd. Always current

5. Company X is a C corporation with estimated annual taxable income of $100,000 inperiods in which its deferred tax liability is expected to be settled. Which of thefollowing federal tax rates should X use to record the deferred tax liability?

a. 35 percentb. 25 percentc. 22 percentd. 34 percent

6. Which of the following can be carried forward indefinitely?a. NOLsb. Section 179 deductionsc. Capital lossesd. Charitable contributions

FIN 48 DisclosuresFIN 48 requires the following disclosures which apply to all entities:

• The entity’s policy on classification of interest and penalties assessed by taxingauthorities

• As of the end of each annual reporting period presented:- The total amounts of interest and penalties assessed by taxing authorities thatare recognized in the statement of operations, and the total amounts of interestand penalties recognized in the statement of financial position.- For positions for which it is reasonably possible that the total amounts ofunrecognized tax benefits will significantly increase or decrease within 12months of the reporting date:

• The nature of the uncertainty• The nature of the event that could occur in the next 12 months that would cause

the change

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• An estimate of the range of the reasonably possible change or a statement thatan estimate of the range cannot be made

- A description of tax years that remain open subject to examination by major taxjurisdictions.

• Public companies only shall include the following additional disclosures as ofthe end of each annual reporting period presented:

- A tabular reconciliation of the total amounts of unrecognized tax benefits at thebeginning and end of the period which shall include at a minimum:

• The gross amounts of the increases and decreases in unrecognized tax benefitsas a result of tax positions taken during a prior period.

• The gross amounts of increases and decreases in unrecognized tax benefits as aresult of tax positions taken during the current period.

• The amounts of decreases in the unrecognized tax benefits relating to settle-ments within taxing authorities.

• Reductions to unrecognized tax benefits as a result of a lapse of the applicablestatute of limitations.

- The total amount of unrecognized tax benefits that, if recognized, would affectthe effective tax rate.

Below are sample disclosures based on the guidance presented above:

EXAMPLE 1 Disclosure: Public Company

Note X: Tax Uncertainties

The Company files income tax returns in the U.S. federal jurisdiction and variousstates (not required).

The Company is subject to U.S. federal and state income tax examinations for taxyears 20X4, 20X5, 20X6, and 20X7.

The Internal Revenue Service (IRS) commenced an examination of the Company’sU.S. income tax returns for 20X3 and 20X4 in the first quarter 20X7, which isexpected to be completed by the end of 20X8. As of December 31, 20X7, the IRShas proposed certain significant tax adjustments to the Company’s research cred-its. Management is currently evaluating those proposed adjustments to determineif it agrees. If accepted, the Company anticipates that it is reasonably possible thatan additional tax payment in the range of $80,000 to $100,000 will be made by theend of 20X8.

A reconciliation of the beginning and ending amount of unrecognized tax benefitsis as follows (public company disclosure only):

Balance at January 1, 20X7 $ 0

Additions based on tax positions related to the current year 210,000

Additions for tax positions of prior years 30,000

Reductions for tax positions of prior years (50,000)

Reductions due to settlements with taxing authorities (40,000)

Reductions due to lapse in statute of limitations (10,000)

Balance at December 31, 20X7 $140,000

The Company’s policy is to record interest expense and penalties assessed bytaxing authorities in operating expenses.

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For years ended December 31, 20X7, 20X6, and 20X5, the Company recognizedapproximately $12,000, $15,000, and $17,000, respectively of interest and penaltiesexpense. At December 31, 20X7 and 20X6, accrued interest and penalties were$50,000 and $45,000, respectively.

Included in the balance at December 31, 20X7 and 20X6 are $30,000 and $25,000,respectively, of tax positions that relate to tax deductions that upon audit could bedisallowed, resulting in a higher effective tax rate. Management believes that it ismore likely than not that these tax positions would be sustained in the event ofaudit (public company disclosure only).

EXAMPLE 2 Disclosure: Nonpublic Company



For years ended December 31, 20X7 and 20X6, the Company recognized approxi-mately $5,000 and $6,000, respectively of interest and penalties expense. At Decem-ber 31, 20X7 and 20X6, accrued interest and penalties were $2,000 and $3,000,respectively.

The Company is subject to U.S. federal and state income tax examinations for taxyears 20X4, 20X5, 20X6 and 20X7.

The Internal Revenue Service (IRS) commenced an examination of the Company’sU.S. income tax returns for 20X3 and 20X4 in the first quarter 20X7 which isexpected to be completed by the end of 20X8. As of December 31, 20X7, the IRShas proposed certain significant tax adjustments to the Company’s research cred-its. Management is currently evaluating those proposed adjustments to determineif it agrees. If accepted, the Company anticipates that it is reasonably possible thatan additional tax payment in the range of $80,000 to $100,000 will be made by theend of 20X8.

EXAMPLE 3 Disclosure: Nonpublic Company - Abbreviated Disclosure

Most nonpublic companies do not have tax positions that require the recording ofan unrecognized liability. In such cases, the disclosures are as follows:



For years ended December 31, 20X7 and 20X6, there was no interest and penaltiesexpense and no accrued interest and penalties recorded.

The Company is subject to U.S. federal and state income tax examinations for taxyears 20X4, 20X5, 20X6 and 20X7.

Fixing the Disclosures in Uncertain Tax Positions for NonpublicEntitiesSince the issuance of FIN 48, the FASB has issued additional guidance with FASB StaffPosition (FSP) FIN 48-1, and ASU 2009-6, Income Taxes: Implementation Guidance onAccounting for Uncertainty in Income Taxes and Disclosure Amendments for NonpublicEntities (ASC 740). ASU 2009-6 amends FIN 48 to eliminate certain disclosures fornonpublic companies and to clarify the scope to which FIN 48 applies. FIN 48, asamended by ASU 2009-6, requires numerous disclosures related to tax positions.

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Among those disclosures are three specific disclosures that have caused contro-versy in practice, particularly with respect to those companies that have no unrecog-nized tax positions recorded on their balance sheets. These include the following:

• The company’s policy on classification of interest expense and penalties as-sessed by taxing authorities

• The total amounts of interest and penalties assessed by taxing authorities thatare recognized in the statement of operations, and the total amounts of interestand penalties assessed by taxing authorities that are recognized in the statementof financial position

• A description of tax years that remain open subject to examination by major taxjurisdictions

In May 2010, the AICPA’s Financial Reporting Executive Committee (FinREC) issued atechnical practice aid, TPA 5250-15, “Application of Certain FASB Interpretation No. 48(codified in FASB ASC 740-10) Disclosure Requirements to Nonpublic Entities That DoNot Have Uncertain Tax Positions.� In that TPA, the AICPA concluded that when anonpublic entity did not have uncertain tax positions, the disclosure found in ASC740-10-50-15(e) of the number of years that remain open subject to tax examination wasstill required to be disclosed. Since issuance of the TPA, critics have argued that theconclusion reached in the TPA is flawed and inconsistent with ASU 2009-6.

In the Basis of Conclusions section of ASU 2009-6, the FASB states:

BC13. The board concluded that the disclosure requirements in paragraph740-10-50-15(c.) through (e) still provide value to users of nonpublic entityfinancial statements even without the disclosure of total unrecognized taxbalances. As a result, the Board decided not to require nonpublic entities todisclose total unrecognized tax positions at the balance sheet dates.

BC14. One respondent asked if a disclosure would be required if manage-ment determined that there are no unrecognized tax benefits to record. TheBoard concluded that such a disclosure would not be required because itwill set a precedent for requiring a similar disclosure for all accountingstandards for which there was no material effect on the financial statements.

Although BC14 does not explicitly identify what “a disclosure� references, at a mini-mum it references the disclosure of the number of tax years that remain open asfollows:

A description of tax years that remain open subject to examination by major taxjurisdictions

The FASB states that if there are no material uncertain tax positions recorded, thedisclosure of “a description of tax years that remain open subject to examination bymajor tax jurisdiction� is not required. But TPA 5250-15 erroneously contradicted theFASB’s conclusion by stating that the disclosure of the number of years open ISrequired even if an entity has no uncertain tax positions recorded. Some respondentshave stated that the AICPA was not inconsistent with the FASB’s position because theBasis of Conclusions section is not formally part of the FASB’s Codification.

Additionally, the FASB and the Private Company Council (PCC) discussed FIN 48at a February 2015 PCC meeting. At that meeting, the FASB reaffirmed its position inParagraph B14 by stating that it did not intend to require disclosure of tax examinationyears that are open when a nonpublic entity does not have any (material) uncertain taxpositions. The result is that a nonpublic entity that has no uncertain tax positionsliability recorded is not required to disclose the number of tax years open forexamination.

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As a result, the AICPA has deleted TPA 5250-15 and has scheduled a reissue of theTPA shortly. That revised TPA will be consistent with ASU 2009-6 and will state that adescription of tax years that are open subject to examination by major tax jurisdictionswill not be required if an entity has no material unrecognized tax positions.

If an entity has no material unrecognized tax positions, the third disclosure(description of tax years open) is not required. But what about the other two disclosuresrelated to interest and penalties? Are they required if an entity has no interest andpenalties related to taxes?

Remember that Paragraph B14 of ASU 2009-6 states:

BC14. One respondent asked if a disclosure would be required if manage-ment determined that there are no unrecognized tax benefits to record. TheBoard concluded that such a disclosure would not be required because it willset a precedent for requiring a similar disclosure for all accounting standardsfor which there was no material effect on the financial statements.

The FASB notes that a disclosure is not required (of open tax years) if there are nounrecognized tax obligations or benefits. The FASB goes on to state that to requiresuch an irrelevant disclosure would not be required because it will “set a precedent”meaning it would result in entities including disclosures on elements that do not exist.In other words, the FASB is saying that it does not want to set a precedent for requiringdisclosures where an item to which the disclosure relates is not material to the financialstatements. The same conclusion should apply to disclosures above involving interestand penalties on taxes. If an entity has no interest or penalties related to their taxes,there is no requirement to disclose the company’s policy to record interest expense andpenalties assessed. Nor is a company required to disclose the total amounts of interestand penalties recognized in the statement of operations and the total amounts of interestand penalties recognized in the statement of financial position assessed by taxingauthorities.

As to the disclosure of the number of years open for examination, no disclosure isrequired if using tax basis financial statements. The reason is because it is not requiredunless an entity has an unrecognized tax benefit liability, which is not recorded for taxbasis financial statements. With respect to the disclosures about interest and penalties,such disclosures would only be required in a year in which an entity that uses the taxbasis of accounting has interest and penalties related to a tax obligation that are eitherrecorded as expense or accrued. Otherwise, no disclosures would be required.

Significance of unrecognized tax benefit liabilities to companyfinancial statementsFor most nonpublic entities, the recording of unrecognized tax benefit liabilities is anonstarter. Such nonpublic entities and their accountants and audits avoid recordingliabilities like the plague. For public entities, where transparency is at a higher level, therecording of unrecognized tax benefit liabilities is a regular event. The key question toask is, how significant are these liabilities?

In March 2014, The Georgia Tech College of Business published a study entitledUnderstanding Unrecognized Tax Benefits. In the Study, the authors examined theunrecognized tax benefits for the firms in the S&P 100. The goal of the study was toclarify the accounting and measurement of the liabilities relative to each entity’s assets,income tax expense, and net income. The results of the study included the following:

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• The median unrecognized tax benefit liabilities was 0.8 percent of total assets,but increased to as high as 9.6 percent for certain companies.

• Seventy-eight percent of the unrecognized tax benefit would reduce net incomeif it were recognized (reversed).

• In general, unrecognized tax benefit liabilities represent an after-tax reserve thatis quite subjective and can have a material effect on income if it were to berecognized (reversed).

The following table presents the liabilities for selected S&P 100 companies:Unrecognized Tax Benefit Liabilities- Selected S&P 100 Companies

Liability Balance % total % average NICompany at 2012 assets (last 3 years)

Accenture $1.6 billion 9.6% 33%

IBM 5.7 billion 4.8% 32%

Dell 2.4 billion 5.1% 97%

Oracle 3.3 billion 4.2% 40%

BOA 3.7 billion .2% 274%

HP 2.6 billion 2.4% 132%

JP Morgan 7.2 billion .3% 22%

Median all companies .8% 11.8%

Source: Georgia Tech Financial Analysis Lab, Understanding Unrecognized Tax Benefits (March 2014)

The above table illustrates the impact that unrecognized tax benefit liabilities have oncertain entities. For some companies, the impact is that the liability is a large percent-age of total assets such as Accenture’s 9.6 percent. For others, the impact is that theliability, if recognized through a reversal, represents a high percentage of net income.For example, Bank of America’s $3.7 billion liability represents 274 percent of averagenet income. If the liability were to reverse in part, it would have a significant impact ofincreasing net income.

Consider the disclosure found in the notes to Honeywell:Balance at beginning of year $815

Gross increases related to current period tax positions 25

Gross increases related to prior periods tax positions 44

Gross decreases related to prior periods tax positions (62)

Decreases related to settlements with tax authorities (40)

Expiration of the statute of limitations for the assessment of taxes (64)

Foreign currency translation 4

Balance at end of year $722

Source: Georgia Tech Financial Analysis Lab, Understanding UnrecognizedTax Benefits (March 2014)

Looking at the Honeywell disclosure above, Honeywell has $722 million of unrecog-nized tax benefit liabilities recorded on its balance sheet at year end. Notice the activityin and out of this liability account consisting of changes in volatile estimates computedbased on a high degree of subjectivity. In reviewing the results of the study, oneconclusion can be easily reached. Unrecognized tax benefit liabilities represent to somecompanies, a significant liability as a percentage of total assets. Furthermore, suchliabilities are very subjective in nature and can be easily manipulated as reserve or“cushion� accounts.

When FIN 48 was issued, its critics warned the FASB that FIN 48 would give theIRS an easy roadmap to audit questionable tax positions. Embedded in the notes to

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financial statements of public companies is a disclosure of the activity in the unrecog-nized tax benefit liability, which FIN 48 requires, and is presented in the followingformat:

NOTE X: Unrecognized Tax Benefit Liability

A reconciliation of the beginning and ending amount of unrecognized taxbenefits is as follows:

Balance at January 1, 20X1 $XX

Additions based on tax positions related to the current year XX

Additions for tax positions of prior years XX

Reductions for tax positions of prior years (XX)

Reductions due to settlements with taxing authorities (XX)

Reductions due to lapse in statute of limitations (XX)

Balance at December 31, 20X1 $XX

Due to the required disclosures under FIN 48, there is far greater transparency into acompany’s tax positions than ever before. Under FIN 48, a company is required torecord a tax liability if the probability is 50 percent or less that a particular tax positionwill be sustained in an IRS or state tax audit. That liability is required and is reflective ofthe uncertainty that exists in a tax position. Thus, the total liability represents thecumulative uncertainty of sustaining the tax benefit of all tax positions. That liability isnot only presented separately on a company’s balance sheet, but also must be recon-ciled in the notes to financial statements. In essence, FIN 48 lays out importantinformation about a company’s tax positions which can be used against it by the IRS or astate tax authority.

If a company has a sizeable balance in its unrecognized tax benefit liability account,that fact suggests that there are several significant positions that may be challengeableby the IRS and other tax jurisdictions. A company is essentially saying that it has takentax positions which it may not be able to support and justify if the company is audited bythe IRS or a state tax authority. Those tax authorities have access to the footnotes thatinclude information on the unrecognized tax benefits.

The list of third parties interested in a company’s FIN 48 information includes notonly the IRS, but also state departments of revenue. Both the IRS and states have avested interest in knowing a company’s tax positions to assist in uncovering potentialunderstated tax liabilities.

There are also a few instances where the IRS or other taxing authorities cross overto use GAAP information to assist them in conducting federal and state tax audits. Theissuance of FIN 48 has given the IRS an opening to use FIN 48 working papers anddisclosure information to identify uncertain tax positions. The IRS has had a long-standing policy of restraint in seeking accountants’ or auditors’ tax accrual workpapers(IRS Announcement 2002-63), requesting them in rare and unusual circumstances orwhere the taxpayer was involved in certain listed transactions. In situations in which theIRS has demanded tax accrual workpapers, they have won in court such as in the caseof United States v. Textron, Inc. (577 F.3d 21 (1st Cir. 2009), in which the court heldthat tax accrual workpapers are not privileged work product.

In early 2010, the IRS issued Announcement 2010-9 to address disclosures ofuncertain tax positions on an entity’s federal tax return. Subsequently, the IRS issuedAnnouncement 2010-75, in which it stated that it was releasing a schedule in whichcertain taxpayers would be required to disclose uncertain tax positions related to theirForm 1120 corporate tax return or other returns. For tax years beginning in 2014 andlater, the asset threshold for reporting uncertain tax positions on Schedule UTP (Form1120) Uncertain Tax Position Statement decreased from $50 million to $10 million.

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Corporations meeting all other Schedule UTP filing requirements must file a ScheduleUTP if total assets equal or exceed $10 million. This asset threshold decrease for 2014was the final phase of the five-year Schedule UTP filing requirement phase-in. The assetthreshold for tax years 2010 and 2011 was $100 million, decreasing to $50 million for taxyears 2012 and 2013.

• A corporation must file Schedule UTP with its income tax return if:

- The corporation files Form 1120, U.S. Corporation Income Tax Return; Form1120-F, U.S. Income Tax Return of a Foreign Corporation; Form 1120-L, U.S.Life Insurance Company Income Tax Return; or Form 1120-PC, U.S. Propertyand Casualty Insurance Company Income Tax Return,

- The corporation has assets that equal or exceed $10 million,

- The corporation or a related party issued audited financial statements reportingall or a portion of the corporation’s operations for all or a portion of thecorporation’s tax year, and

- The corporation has one or more tax positions that must be reported onSchedule UTP.

• On the Schedule UTP, the taxpayer must:

- Disclose a concise description of each uncertain tax position, and

- Rank all of the reported tax positions based on the federal income tax reserverecorded for the position taken on the tax return, and designate the tax positionsto which the reserve exceeds 10 percent of the aggregate amount of reserve forall tax positions reported.

• The types of tax positions that require disclosure on the Schedule UTP include:

- Uncertain tax positions for which a taxpayer has recorded a reserve in itsaudited financial statements, and

- Uncertain tax positions for which the corporation did not record a reservebecause the corporation expects to litigate the tax position.

• The Schedule is not applicable to pass-through entities although the IRS hasauthority to extend the application of Schedule UTP to pass-through entities ortax-exempt organizations.

In Announcement 2010-76, the IRS stated that it has expanded its policy of restraint inconnection with its decision to require certain corporations to complete Schedule UTP,and will forego seeking particular documents that relate to uncertain tax positions andthe workpapers used to prepare the Schedule UTP. Although the IRS may not seek useof tax accrual workpapers, the IRS has announced that it is using the footnote disclo-sures required by FIN 48 to audit uncertain tax positions. In 2007, the IRS LargeBusiness and International Division (LB&I) issued FIN 48 Implications LB&I FieldExaminers’ Guide.

Moreover, recent cases in which the IRS has sought copies of tax accrualworkpapers, the decisions have been split. These include the following:

• On June 29, 2010, the U.S. Court of Appeals for the District of Columbia Circuitfound that documents the government subpoenaed from Dow Chemical Com-pany’s independent auditors were protected from discovery under the work-product doctrine. U.S. v. Deloitte, LLP, 106 AFTR 2d 2010-5053.

• The IRS won a victory in Textron Inc. (discussed previously) where the U.S.Court of Appeals for the First Circuit rejected the taxpayer’s argument that itstax accrual workpapers were entitled to work-product protection.

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• More recently, the issue was revisited in response to the IRS’s summons ofKPMG’s tax accrual workpapers related to Wells Fargo. In June 2013, the U.S.District Court for the District of Minnesota ruled that Wells Fargo’s measure-ment of and analysis with respect to its so-called uncertain tax positions, orUTPs, is entitled to work product protection, but that the identification of thetypes of UTPs is not. The court determined that the work-product doctrine didnot protect from disclosure the identification of UTPs and related factual infor-mation because that information is created in the ordinary course of business.

So the fundamental question to be asked is, are FIN 48 Disclosures a Roadmap for theIRS?

IRS Answer: The disclosures required under FIN 48 should give the Service asomewhat better view of a taxpayer’s uncertain tax positions; however, the disclosuresstill do not have the specificity that would allow a perfect view of the issues and amountsat risk. For example, there may be a contingent tax liability listed in the tax footnotes ofa large multi-national taxpayer with a description called “tax credits,� however, taxcredits could be U.S., foreign, or state tax credits. So the “tax credits� in this example,may or may not have a U.S. tax impact. Even with the lack of specificity, tax footnotesincluded in financial statements, including FIN 48 disclosures, should be carefullyreviewed and analyzed as part of the audit planning process. For example, if a taxpayerreflecting a contingent tax liability in the year under audit for Subpart F income doesnot reflect Subpart F in the tax return, questions could develop about why Subpart Fincome does not appear in the tax return, but is mentioned in the tax footnotes ascreating a contingent tax liability.

State tax agencies also have a strong interest in FIN 48 information. With sizeablebudget shortfalls, going after companies that have underreported state taxes providesthe states with the opportunity to retrieve significant tax revenue. In particular, statesare using FIN 48 information to attack two particular areas of vulnerability forcompanies:

• Factors that lead to nexus within a particular state

• Computation of apportionment

Because of the current state tax environment in which many states are creating theirown rules as to whether there is state nexus, it may be difficult to conclude whetherthere is a more-than-50-percent likelihood that a company’s position will be challenged.

COMMENT: One approach a company can take to avoid disclosing informa-tion about its tax positions is to remove the disclosure from its financial statementsand reference a GAAP departure in the auditor’s report.

Regardless of what the IRS says about its focus or lack thereof on FIN 48 disclosures, arecent study suggests the IRS is particularly focused on corporate disclosures. InOctober 2014, a group of educators published a study (IRS Attention, Zahn Bozanic,Jeffrey L. Hoopes, Jacob R. Thornock, and Braden M. Williams) which examined IRSdownload (through IP addresses) timing and frequency patterns of firms’ annual reportsfrom EDGAR, which has the mandatory SEC disclosures, and noted the following:

• Despite the IRS having large amounts of private information on companies, IRSagents are pulling information from the EDGAR database of required publicfilings based on certain areas of interest.

- There is a high pattern of downloads from “9 to 5� with a significant dropoffafter those hours and on weekends.

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- The patterns indicate that human beings, rather than computer algorithms, arepulling information from EDGAR during IRS hours.

- The average downloaded 10-K is more than one year old (448 days on average)

suggesting that the financial statements are being used for tax enforcementpurposes and not for information content purposes.

• The IRS attention is strongly driven by firm characteristics such as:

- Firm size

- Foreign profitability

- NOLs

• There is a strong correlation between IRS attention to certain information anduncertain tax positions supporting the conclusion that the FIN 48 disclosuresprovide a roadmap to the IRS.

- The IRS attention after the effective date of FIN 48 has been four times greaterthan other U.S. government agencies.

- The IRS has particular interest in 10-K filings especially since companies havebeen reporting uncertain tax positions under FIN 48.

• Four financial statement measures appear to be used by the IRS and arecorrelated with information used

- Cash effective tax rate (Taxes paid/Pretax income)

- GAAP effective tax rate, including the breakdown of current, deferred, andforeign/domestic taxes

- Book/tax differences

- Unrecognized tax benefits liabilities (UTB)

• A lower cash effective rate (cash ETR) is correlated with higher IRS attention.

Cash effective tax rate:

Income taxes paid XX = Cash effective tax rate

Pretax income XX

• There is a strong correlation between IRS attention and the geographic footprintdisclosed in the 10-K such as number of subsidiaries in tax havens, number ofsubsidiaries in foreign countries, and number of geographic segments disclosedin the financial statements.

COMMENT: IRS attention has increased in measures of multinationaloperations but not for the measures of tax complexity.

• Certain information found in the 10-K discloses important information that isused in tax avoidance and that is not reported to the IRS elsewhere such as:

- Narrative descriptions of company goals

- Management style

- Intentions behind M&A activities

- Estimations about future business prospects

- Supply chain

- Business operations

- Products

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- Strategy

- Competition

• The IRS focus on disclosures increased after the effective date of Schedule M-3and Schedule UTP.

FASB continues to increase income tax disclosuresIf FIN 48 disclosures were not enough, the FASB is at it again. This time, the FASB hasproposed increasing disclosures of undistributed foreign earnings as part of its disclo-sure framework project. Although the framework project is supposed to streamlinedisclosures, requiring additional disclosures of undistributed foreign earnings appearsto be going in the opposite direction. In its February 2015 meeting, the FASB decidedthat entities would be required to disclose the following:

• Income before taxes disaggregated between domestic and foreign earnings.Foreign earnings would be further disaggregated for any country that is signifi-cant to total earnings.

• Domestic tax expense recognized in the period for taxes on foreign earnings

• Undistributed foreign earnings that are no longer asserted to be indefinitelyreinvested during the current period and an explanation of the circumstancesthat cause the entity to make that assertion. Separate disclosure should be madefor any country that is significant to the disclosed amount.

• A further disaggregation of the current requirement to disclose the temporarydifference for the cumulative amount of indefinitely reinvested foreign earningsif any country represents at least 10 percent of the disclosed amount

The FASB decided not to require disclosure of the following:

• Disaggregation of deferred tax liabilities (DTL) recorded for unremitted foreignearnings by country

• An estimate of the unrecognized DTL on the basis of simplified assumptions

• Past events or current conditions that have changed management’s plans forundistributed foreign earnings

COMMENT: According to several studies, U.S. company profits and cashheld off shore exceed $2 trillion. Those companies are not motivated to repatri-ate the profits and cash to the United States given the existing corporate tax rateof 35 percent. One firm estimated that the amount of foreign earnings remainingoff shore increased by 93 percent from 2008 to 2013 (Audit Analytics 2014, asreported by Thompson Reuters).

Impact of Reduction in Tax Rates on Deferred TaxesFor the past decade, there have been numerous proposals and suggestions that U.S.corporate tax rates should be reduced as part of an overall tax reform. In the jointcommittee report entitled, The Moment of Truth: Report of the National Commission onFiscal Responsibility and Reform (Report issued by the National Commission on FiscalResponsibility and Reform), the committee recommended that the top corporate federaltax rate be reduced from 35 percent to a rate within the range of 23-29 percent.Recently, the Treasury and White House mentioned a 25 percent target rate.

The current U.S. corporate tax rate is 35 percent, which is considered one of thehighest among all countries. When one adds a state tax rate in the 5 to 10 percentrange, net of the federal tax benefit, most corporations have a federal and state effectivetax rate that exceeds 40 percent. According to the Tax Foundation, the following isnoted (Tax Foundation, Corporate Income Tax Rates Around the World, 2014):

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• The United States has the third highest general top marginal corporate incometax rate (federal and state) in the world at 39.1 percent, exceeded only by Chadand the United Arab Emirates, and the highest federal corporate income tax rateamong the 34 industrialized nations of the Organization for Economic Coopera-tion and Development (OECD).

• The worldwide average top corporate income tax rate is 22.6 percent (30.6percent weighted by GDP).

• By region, Europe has the lowest average corporate tax rate at 18.6 percent(26.3 percent weighted by GDP); Africa has the highest average tax rate at 29.1percent.

• Larger, more industrialized countries tend to have higher corporate income taxrates than developing countries.

• The worldwide (simple) average top corporate tax rate has declined over thepast decade from 29.5 percent to 22.6 percent.

• Every region in the world has seen a decline in their average corporate tax ratein the past decade.

Corporate Tax Rates By Country

CorporateCountry Tax Rate

United Arab Emirates 55%

Chad 40%

United States 35%

Japan* 37%

France 34.4%

India 34%

Australia 30%

UK 21%

Italy 27.5%

Greece 26%

Mexico 30%

Spain 28%

Austria 25%

Israel 26.5%

Sweden 22%

Ireland 12.5%

Switzerland 8.5%

Bahamas 0%

British VI 0%

Bermuda 0%

Worldwide average 22.6%

* Japan has approved tax reform that will lower its corporate rate.Sources: Tax Foundation and Organization for Economic Co-operation andDevelopment (OECD)

As corporate tax revenues decline and U.S. companies continue to hold more than $2trillion of cash off shore, there is impetus to reduce the U.S. corporate tax rate from 35percent to a rate that is in the 25 to 28 percent range.

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STUDY QUESTIONS

7. Based on the study, The Effects of Tax Reform on Deferred Taxes: The Winners andLosers, which of the following industries would benefit from a reduction in tax rates?

a. Pharmaceuticals

b. Biotechnology

c. Financial companies

d. Oil and gas exploration

8. Which of the following statements is correct with respect to the Tax Foundation’sstudy entitled Corporate Income Tax Rates around the World, 2014?

a. The worldwide average top corporate income tax rate is 35 percent.

b. Europe has the highest average tax rate at 29.1 percent.

c. Africa has the lowest average tax rate at 22.6 percent.

d. The United States has the third highest general top marginal corporate incometax rate in the world.

9. Based on the Tax Foundation’s study entitled Corporate Income Tax Rates around theWorld, 2014, which country had the highest corporate tax rate?

a. United Arab Emirates

b. Australia

c. United States

d. Switzerland

CPE NOTE: When you have completed your study and review of chapters 1-3, whichcomprise Module 1, you may wish to take the Final Exam for this Module. Go toCCHGroup.com/PrintCPE to take this Final Exam online.

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61

MODULE 2: FINANCIAL STATEMENTREPORTING—CHAPTER 4: FinancialPerformance Reporting by BusinessEnterprises¶401 WELCOMEOver the past decade, the financial community has been fickle in conveying to theFASB, SEC and others the type of financial information it would like to see in financialstatements and related disclosures. Unfortunately, events such as the Enron andWorldCom frauds have resulted in the passage of the over-reaching provisions ofSarbanes-Oxley, which created a new oversight board (PCAOB), expansive auditingrequirements, Section 404 compliance, and a host of extensive rules and regulationscosting billions to implement and manage. This chapter examines studies and recom-mendations that will hopefully lead to a comprehensive business reporting model that isvaluable from the investor’s perspective.



• Identify some of the 12 recommended principles for the Comprehensive Busi-ness Reporting Model

• Recall the definition of free cash flow

• Recognize some of the key ratios used to analyze working capital

• Identify some of the symptoms of inefficiently managed working capital

¶403 INTRODUCTIONOver the past decade, the financial community has been fickle in conveying to theFASB, SEC and others the type of financial information it would like to see in financialstatements and related disclosures.

First, there were the Enron and WorldCom frauds in the early 2000s, which createdan onslaught of demand for further transparency, additional disclosures, and therecording of off-balance-sheet transactions. Investor demand for more informationculminated with the passage of the Sarbanes-Oxley Act of 2002. As history has shown,single, sizeable events, such as the Enron and WorldCom frauds, can result in thepassage of bad law, as evidenced by the over-reaching provisions of Sarbanes-Oxley,which created a new oversight board (PCAOB), expansive auditing requirements,Section 404 compliance, and a host of extensive rules and regulations costing billions toimplement and manage.

Interestingly, even though there were several sizeable frauds that occurred in theearly 2000s, the expansive changes made by Sarbanes-Oxley were disproportionate tothe satisfaction level of financial statement users. For example, financial statement userswanted some improvement with disclosures as they rated the quality of information asbeing good to average. Yet, Sarbanes-Oxley expanded various requirements as if theoverall financial reporting system was broken, which it was not.

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Thus, it appeared that the additional demands of Sarbanes-Oxley were made at thewill of Congress and the SEC, within an over-reactive, politically charged climate.

¶404 FINANCIAL COMMUNITY’S VIEW OF FINANCIALREPORTING AND DISCLOSURESRight after the passage of Sarbanes-Oxley, in 2003, AIMR did a survey to determine theextent to which portfolio and fund managers and securities analysts were satisfied withthe quality of financial reporting and disclosures. At the time of the survey, the effects ofthe changes made by Sarbanes had not been felt. Therefore, one should treat theseresults as being part of a pre-Sarbanes survey.

The survey, conducted by AIMR, entitled Global Corporate Financial ReportingQuality, asked: How do you rate the quality of the financial reporting and disclosuresyou receive? The results were as follows:

Good to excellent 45%

Average 44%

Below average 7%

Poor 1%

No answer 3%

100%

The survey further sought to determine the interrelation between the importanceof financial information and disclosures, and quality of that information, by category.Only 45 percent of those surveyed rated the information they received in the pre-Sarbanes environment as either good or excellent.

The results of the survey suggested the following:

• There was a real disconnect between the importance of certain financial informa-tion and the perceived quality of that information. In particular, the respondentssuggested that the quality of disclosures was generally poor relative to theirimportance. For example, the survey suggested that overall, the importance offootnotes was either very or extremely important (85 percent of the respon-dents) while only 35 percent of those respondents stated that the overall qualityof the footnotes was good to excellent.

• Only 34 percent of the respondents noted that overall footnotes improved while10 percent said they had not improved.

• At the time of the survey, the top 10 disclosures of most importance were:% very or extremely important

Off-balance-sheet items 83%

Extraordinary, unusual, non-recurring charges 78%

Pension and other retirement benefits 76%

Contingencies, litigation, legal risks 73%

Explanation of accounting principles 72%

Revenue recognition criteria 72%

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63MODULE 2 - CHAPTER 4 - Financial Performance Reporting

% very or extremely important

Costs capitalized versus expensed 70%

Segment reporting 71%

Forward-looking information 70%

Risk factors, sensitivity of assumptions 69%

A Second StudyAs a further study on evaluating the financial reporting model, the Centre for FinancialMarket Integrity (CFA Institute) issued a report after Sarbanes-Oxley entitled A Com-prehensive Business Reporting Model, Financial Reporting for Investors. In its report,CFA outlined the comprehensive business reporting model that is important from theinvestor’s perspective, and outlined 12 principles for a comprehensive reporting modelas summarized in the following chart:

12 Recommended Principles for a Comprehensive Business Reporting Model

Principle Reason for Importance of Principle

The company must be The current common shareholder is the last to receive a share of theviewed from the company’s assets and earnings. The common shareholder must haveperspective of a current complete, accurate information about all other claims that will be paidinvestor in the before it gets paid including potential risk exposures and possiblecompany’s common returns.equity.

Fair value information is Currently, financial statements include some items reported atthe only information historical cost and others at fair value, under a mixed-attribute system.relevant for financial Decisions about whether to purchase, sell, or hold investments aredecision making. based on the fair values of the investments and expectations about

future changes in their values. Financial statements based on outdatedhistorical costs are less useful for making such assessments.

Recognition and Financial information may be completely reliable if it is easilydisclosure must be verifiable using one or more criteria. Yet, such information may not bedetermined by the relevant for financial decision making. For example, the purchase by arelevance of the company of a major manufacturing facility 30 years ago at recordedinformation to cost is easily verifiable. However, such information is not useful orinvestment decision relevant for today’s decision making.making and not basedupon measurementreliability alone.

All economic The purpose of financial reporting is to convey the economic positiontransactions and events of the company and changes in that position to investors. Reportingshould be completely methods that omit or fail to reflect the economic essence of events andand accurately transactions as they occur do not achieve the purpose of financialrecognized as they occur reporting.in the financial All activities that are currently off the balance sheet must bestatements. recognized, including executory contracts.

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Investors’ wealth Under current practice, materiality is typically determined by theassessments must company or auditor using some arbitrary threshold such as fivedetermine the percent of an income statement or balance sheet number.materiality threshold. Financial statements are prepared for investors who need

information and who base their financial decisions upon it. Themateriality threshold should be based on what will affect investors’decisions and not upon preparers’ arbitrary assessments (e.g., fivepercent of net income or assets). These decisions should be based onboth quantitative and qualitative factors. Example: A small amount offraud committed by company managers would likely be consideredhighly material to investors in assessing the integrity of those towhom they entrust their assets.

Financial reporting must Reporting of economic transactions and events should not bebe neutral. influenced by the outcomes of the financial reporting or the effects

that the reporting may have on one or more interests. In the past,concern for outcomes has caused political forces to challengestandard setters.

Example: During the stock option debate, those opposed toexpensing stock options argued that expensing would reduce netincome, causing companies that issue options to reduce the number ofoptions granted to employees, making it more difficult to attracttalented employees.

Example: Pension accounting does not present fair value because ofprevious pressures placed on the FASB to water down its standards.

All changes in net assets Under present practice, changes in net assets are scatteredmust be recorded in a throughout the financial statements in the income statement, cashsingle financial flow statement, balance sheet, and changes in stockholders’ equity.statement: the Statement Further, the netting and aggregation of transactions makes analyses ofof Changes in Net Assets changes in net assets difficult.Available to Common All changes in net assets should be reported clearly andShareholders. understandably and in a single statement. Investors must now expend

great effort to locate these changes and make use of them. Further,investors must resort to a great deal of analysis to determine thesource and magnitude of many asset changes.

The Statement of If investors are to be able to evaluate how the value of their investmentChanges in Net Assets is increasing or decreasing, they must be able to fully understand theAvailable to Common change in fair value of the assets they hold and the obligations theyShareholders should have incurred. The clearest measures of a company’s wealth-include timely generating or consuming patterns are changes in the fair values ofrecognition of all these assets and obligations.changes in fair values of The Statement should also reflect the changes in fair valueassets and liabilities. including remeasurements due to changes in interest rates.

Delayed recognition of fair value, such as the unrealized gain or lossrelated to available-for-sale securities should be eliminated so that allgains and losses flow through the income statement.

The cash flow statement Under present practice, few companies use the direct method ofprovides essential presenting the operating activities of the statement of cash flows. Ainformation and should clear picture of the company’s current means of generating cash flows,be prepared using the the patterns of those cash flows, and its effectiveness in producingdirect method only. cash is essential. The current cash flow statement format of most

companies does not provide this information.

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Changes affecting each Today, most company financial statements are highly summarized andof the financial condensed. Aggregation of information with different economicstatements must be attributes, different measurement bases, trends, and operationsreported and explained results in substantial loss of information.on a disaggregatedbasis.

Individual line items Under current practice, information in financial statements isshould be reported aggregated in major functional categories, such as cost of goods soldbased on the nature of and selling, general, and administrative activities.the items rather than the The forecasting of individual line items for use in valuation andfunction for which they other decisions requires that they be relatively homogeneous andare used. represent a single economic attribute or an aggregation of very similar

attributes. For example, labor cost, pension cost, materials cost,energy cost, etc. that are part of cost of goods sold should be reportedindividually as each has very different economic characteristics,trends, and measurement bases.

Disclosures must In current practice, disclosures vary widely in both quality andprovide all the additional quantity. Investors must have sufficient supplementary disclosures toinformation investors evaluate the numbers, including:require to understand • Financial reporting methods usedthe items recognized in • Models used for estimation and measurementthe financial statements, • Assumptions usedtheir measurement • Sensitivity analyses of point estimatesproperties, and risk • Information about risk exposuresexposures. • Information explaining why changes in important items have

occurred

The Disclosure Overload (Or, be careful what you ask for . . . )

As you can see from the two reports previously discussed, in the wake of Enron andWorldCom, investors and third party users wanted more financial information anddisclosures and they certainly received it.

During 2003 to 2014, there were several new accounting pronouncements issued inresponse to requirements of Sarbanes-Oxley, the SEC, and the FASB. Some of thepronouncements were issued in response to requirements of Sarbanes-Oxley, such asthe issuance of FIN 46R, the consolidation of variable interest entity rules, and thenewly issued revenue recognition standard.

Now, after a decade of expanded disclosures and new GAAP standards, investorsand third-party users are complaining that they are inundated with too many disclosuresand far too much information. The result is that they want more quality and lessquantity of information.

Let’s first look at some statistics based on a recently issued KPMG/FEI study:

• In the 20 years since 1994, there have been more than 200 new GAAP docu-ments issued in the form of Emerging Issues Task Force (EITF) consensuses,new GAAP statements, Accounting Standards Updates (ASUs), SEC Staff Ac-counting Bulletins (SABs), and Financial Reporting Releases, along with manyinterpretive guidance related to these documents (Disclosure Overload andComplexity: Hidden in Plain Sight, KPMG and FEI, 2012). In fact, a largenumber of those new standards have been issued during the period 2003 toearly 2015.

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• The volume of new standards has accelerated since the Sarbanes-Oxley Act withgrowing pressure placed on the FASB to “clean up� accounting standards, withparticular interest in resolving GAAP for revenue recognition and off-balance-sheet transactions.

• The anticipated convergence with international standards has created an impe-tus for the FASB to accelerate new standards involving the FASB-IASB jointprojects including leases, revenue recognition, and financial instruments, amongothers.

• The SEC’s mandate that each financial statement disclosure be tagged in XBRLhas resulted in the cost of each additional disclosure increasing.

A sample of those pronouncements issued from 2003 to early 2016, is noted in thechart below:

Selected Pronouncements Issued 2003 to 2016

Original Reference Pronouncement

FIN 45 Guarantor’s Accounting and Disclosure Requirements for Guarantees

FIN 46-R Consolidation of Variable Interest Entities

FAS 158 Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans

FAS 157 Fair Value Measurements

FAS 123 Share-Based Payment (Stock Options)

FAS 159 Fair Value Option

FASs 141R and 160 Business Combinations and Non-Controlling Interests

FAS 161 Disclosures about Derivative Instruments and Hedging Activities

FAS 156 Accounting for Servicing of Financial Assets

FAS 166 and ASU 2009-16 Accounting for Transfers of Financial Assets

FAS 132 Disclosures About Pensions and Other Postretirement Plan Assets

ASU 2009-05, ASU 2009-12, Fair Value Measurements and Disclosuresand ASU 2010-06

ASU 2010-20 Disclosures about the Credit Quality of Financial Receivables and theAllowance for Credit Losses

ASU 2012-02 Intangibles—Goodwill and Other: Testing Indefinite-Lived IntangibleAssets for Impairment

ASU 2013-04 Liabilities (Topic 405): Obligations Resulting from Joint and SeveralLiability Arrangements for Which the Total Amount of the Obligation IsFixed at the Reporting Date (a consensus of the FASB Emerging IssuesTask Force)

ASU 2014-09 Revenue from Contracts with Customers (Topic 606)

ASU 2014-10 Development Stage Entities

ASU 2014-17 Business Combinations (Topic 805): Pushdown Accounting (a consensusof the FASB Emerging Issues Task Force)

ASU 2014-18 Business Combinations (Topic 805): Accounting for IdentifiableIntangible Assets in a Business Combination (a consensus of the PrivateCompany Council)

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Selected Pronouncements Issued 2003 to 2016

Original Reference Pronouncement

ASU 2015-01 Income Statement- Extraordinary and Unusual Items (Subtopic 225-20):Simplifying Income Statement Presentation by Eliminating the Conceptof Extraordinary Items

Source: The Author

The list of pronouncements identified in the previous chart is only a small sampleof the total population of new pronouncements issued from 2003 to early 2016.

Take a look at any annual report of a public company and read the pages offootnotes. Any rational person will conclude that there is no shortage of disclosures. Aremost of the disclosures meaningful to the end user?

One study suggests that the volume of disclosures has expanded, but not necessa-rily the quality. The study reviewed selected annual reports for the period 2004 to 2010.Updated information from 2010 through early 2016 has not yet been published althoughit is assumed that the results will show a similar pattern.

Consider the following results from the KPMG/FEI Report (Disclosure Overloadand Complexity: Hidden in Plain Sight, KPMG and FEI, 2012):

1. Disclosures found in 10-k reports have expanded approximately 16 percentoverall during the six-year period from 2004 to 2010, and footnote disclosure havegrown 28 percent over the same period as noted in the following chart:

Mean Increase 2004 to 2010

Volume of Form 10-K pages 16%

Volume of footnote disclosure pages 28%

Source: Disclosure Overload and Complexity: Hidden in Plain Sight, KPMG/FEI

The pace of the increase in disclosures has been just as brisk from 2011 to 2015.Although not quantified, all indication is that the increase in the volume of disclosuresfor nonpublic entities is at least as high as that for public companies.

2. Over the six-year period 2004 to 2010, there was approximately a 50-percentgrowth in the volume of footnote disclosures related to pensions and other postretire-ment benefits.

Take a look at the following excerpts from the survey that compared certain datafrom 2004 to 2010. (The survey did not expand into periods after 2010.)

Comparison- Number of Pages in Footnotes

Number of Pages % increase

2004 2010

Archer Daniels Midland 20 42 110%

Wells Fargo 45 109 142%

Target 10 28 180%

Johnson & Johnson 19 27 42%

AT&T 25 40 60%

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Comparison- Number of Pages in Footnotes

Number of Pages % increase

2004 2010

IBM 43 63 47%

Wal-Mart 12 23 92%

Source: Disclosure Overload and Complexity: Hidden in Plain Sight, KMPR/FEI, 2012, as modified bythe author

NOTE: Footnote disclosures have grown at a rapid pace with particularexpansion in the areas of pension and post-retirement benefits, fair value, financialderivatives and hedges. An important contributor to disclosure overload is in-creased complexity of the underlying transactions, investments, financial instru-ments, and relationships.

Financial Statement User CommentsThe KPMG/FEI study states that financial statement users complain as to the quality ofthe disclosures and readability issue when trying to comprehend the information in thefinancial reports. Many users believe that complexity in financial reporting confusesinvestors and therefore they cannot make optimal decisions. Users have becomeconcerned that the proliferation of required disclosures makes it difficult to decipher acompany’s performance and factors that drive performance.

Investors are concerned with longer and more opaque annual reports because:

• More complex (longer and less readable) filings are associated with loweroverall trading.

• There appears to be an association between report complexity and lower abnor-mal trading.

• Smaller investors reduce their trading when filings increase in length of pages.

Preparer CommentsMany preparers of financial statements find the requirements for reporting financialinstruments too complex. In fact, some preparers are concerned that the direction of theFASB and IASB toward principle-based standards will result in further confusion andcomplexity in disclosures.

Consider the following results from the same survey as they relate to preparerissues:

• Preparers are concerned about the amount and speed of changes in regulationsgoverning financial reporting. While there is some support for recent improve-ment in accounting for impairments, there is frustration that some standards areinconsistent, which makes it harder for preparers to see financial reports as afair reflection of the business in question.

• Some preparers believe that many of the disclosures are either unnecessary fortheir businesses or create confusion around the total remuneration for execu-tives when they use complex reward mechanisms.

General ConclusionsThe study offers the following conclusions reached by both users and preparers:

• Complexity of accounting standards and volume of mandated disclosures arethe most significant contributors to the issue of disclosure complexity. Fair

¶404


value, derivatives and hedging are the most significant sources or causes ofdisclosure complexity under specific GAAP requirements.

• Overall, SEC initiatives (e.g., the plain English initiative) to reduce disclosurecomplexity have not had much impact.

• Most companies have not taken steps to reduce disclosure complexity in theirfinancial statements and continue to include numerous disclosures (material andimmaterial) in their notes.

• Companies are reluctant to omit disclosures (other than those that are clearlyimmaterial), out of concern that the SEC or auditor will require the company torevise its reporting to include the immaterial item.

- 61 percent are concerned that the SEC or other regulators will object to theremoval of a disclosure, even if immaterial.

- 56 percent are concerned that the external auditors will object to the removal ofthe disclosure, even if immaterial.

- 71 percent say once a disclosure is included in notes, financial statement orpublic filing, it is rarely or never omitted from future financial statements orfilings, resulting in an accumulation of excess disclosures over several years.

• Companies over disclose to protect against potential litigation:

- 73 percent say their company’s disclosures are influenced by concerns overpotential future litigation.

- Most companies stated that their inside or outside legal counsel does notsignificantly direct disclosure in some or all parts of public filings or footnotes tofinancial statements.

- 71 percent say that if legal counsel is significantly involved with disclosures, itis likely to involve risk factors.

• Most respondents stated that the complexity of accounting standards andvolume of mandated disclosures are significant contributors to disclosurecomplexity.

- Almost all respondents stated financial reporting preparation time and informa-tion review time are impacted by expanded disclosure requirements.

- Fair value and derivatives and hedging requirements is a primary source orcause of disclosure complexity.

NOTE: With respect to complexity, not only has the volume of footnotesgrown at a rapid pace, but the topics of disclosure have also become morecomplex. Such complex topics include new standards and disclosures aboutvariable interest entities, derivative instruments, pensions and other post-retire-ment benefits and fair value. In fact variable interest entities and the financialreporting concepts that they embody only came into being within the lastdecade. The FASB’s multiple attempts to issue guidance on variable interestentities illustrates that, even for these sophisticated and knowledgeable stan-dards setters, this accounting and disclosure has been abnormally challenging.

• Information presented on the face of the financial statements has a greaterimpact on users’ understanding of the information than if provided in a footnote.

Recommendations from the StudyThe respondents developed the following recommendations to streamline disclosureswithout sacrificing important information:

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• The SEC should issue an interpretive release to address the permissibility ofcross-referencing to avoid duplicate disclosures including business description,risk factors, accounting policies, litigation and other contingencies; and themanner of addressing immaterial items. (Note that both the FASB and SEChave issued guidance that indicates that requirements need not be applied toimmaterial items. Many registrants are concerned that any omission will lead toSEC staff comments and potential amendments to filings. One possible approachwould be a single footnote that briefly identifies disclosures omitted due toimmateriality.)

• Summaries of significant accounting policies and discussions of newly imple-mented or soon to be implemented accounting policies should not include adetailed description of patently immaterial matters.

• Disclosures in the financial statements and elsewhere should make maximumuse of tables and graphics and avoid the use of long textual discussions.

• The SEC should move forward with its 21st Century Disclosure Project andshould consider rulemaking to permit companies to omit or incorporate byreference information included in other filings that continue to be available onthe company’s or SEC Web site.

• The FASB should accelerate work on its Disclosure Framework project toestablish a systemic approach to disclosure that properly balances disclosureconsiderations.

• Disclosure of risk factors should be limited to company-specific unique risks andshould not recite the obvious risks of the general environment.

NOTE: Risk factor disclosure in most periodic filings was observed to gomuch further than the rule, which made it difficult to determine factors thatwere truly matters for concern from those that were routine general risks. As aresult of the volume of routine risk disclosures, readers are tempted to skimthese factors and thus there is a greater chance that they will fail to read theuniquely risky factors.

• Both public and private companies should be permitted to omit interim perioddisclosures concerning financial statement items that have not substantiallychanged since the end of the prior fiscal year.

• The FASB and SEC should take various incremental procedures in considera-tion of cost-benefit analysis as a part of developing proposals for new accountingstandards.

NOTE: In particular, the respondents believe that the FASB should con-sider any new disclosure requirements from the context of the overall currentdisclosure environment rather than considering disclosure from the perspectiveof each individual topic as it is addressed in standards-setting. This macrodisclosure consideration, together with more rigorous cost-benefit analysis andfield testing of disclosures should be considered prospectively andretrospectively.

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STUDY QUESTIONS

1. Which of the following is correct as it relates to the current practice of determiningfinancial statement materiality as noted in the report entitled, A Comprehensive Busi-ness Reporting Model?

a. Materiality is typically determined by the investor or other third party usingsome arbitrary threshold.

b. Materiality is typically measured using a statistical, computed threshold.

c. The materiality threshold should be based on what will affect investors’decisions and not upon preparers’ arbitrary assessments.

d. Materiality should reflect only quantitative factors.

2. According to one study, if a company includes a disclosure in its notes, which of thefollowing is correct?

a. That disclosure usually has a shelf life of one year before it is replaced.

b. It is rarely omitted from future financial statements or filings.

c. That disclosure begins as a quantitative disclosure and is converted to aqualitative one in either the second or third year.

d. If it is an SEC company, a regulator typically will make the company changethe disclosure.

¶405 FASB STARTS UP FINANCIAL PERFORMANCEREPORTING PROJECTIn 2014, the FASB has announced that it was starting up its financial statementpresentation project which stalled in 2011. The project was renamed Financial Perform-ance Reporting Project.

The objective of the project is to evaluate ways to improve the relevance ofinformation presented in the performance statement (income statement). The projectwill explore and evaluate improvements to the performance statement that wouldincrease the understandability by presenting certain items that may affect the amount,timing, and uncertainty of an entity’s cash flows.

In July 2010, the FASB staff issued Staff Draft of an Exposure Draft on FinancialStatement Presentation, which reflected the FASB’s and IASB’s cumulative tentativedecisions on financial statement presentation at that time.

Key proposed changes identified in the Staff Draft included:

• Financial statements would be functionalized and separated into five maincategories as follows:

- Business section

- Financing section

- Income taxes section

- Discontinued operations section

- Multi-category transaction section

• The indirect method of presenting the operating activities section of the state-ment of cash flows would be replaced by required use of the direct method.

• The use of the term cash equivalents would be eliminated in the statement ofcash flows and statement of financial position and replaced with the term cash.

• The statement of comprehensive income would replace the statement of income.

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In 2011, the financial statement presentation project was one of the top priorities atthe FASB. But, given the importance of other projects, including revenue recognition,financial instruments, and leases, the financial statement project was taken off theFASB’s docket.

The FASB announced it was bringing the financial statement project back to lifeunder the name Financial Performance Reporting Project. The plan is to bring theproject back as a re-scoping of a research project.

Although the project is in its infancy, the direction of the changes being consideredis significant and would dramatically change the way in which financial statements arepresented. Moreover, the scope of the project is supposed to include both public andnon-public entities, alike.

The FASB has directed the FASB Staff to focus on the following two areas withinthe scope of the project:

• A framework for determining an operating performance metric

• Distinguishing between recurring and nonrecurring or infrequently occurringitems within the performance statement.

In addition, the project will address potential related changes that may include thefollowing areas:

• Additional disaggregation in the performance (income) statement

• Transparency of remeasurements

• Related changes to segment reporting

• Linkages across the primary statements

Changes in the financial statement format and presentation would have someobvious impacts as follows:

• The cost of such a change would be significant. Everything from textbooks tointernal and external financial statement formats would have to be changed. Thechange to the direct method alone would be costly.

• There could be significant fluctuations in comprehensive income from year toyear as more items are brought onto that statement than were not on the incomestatement before.

• Contract formulas for bonuses, joint ventures, etc. that are based on GAAP netincome would have to be rewritten.

• Tax return M-1 reconciliations would differ.

Project update: At the January 20, 2016 FASB meeting, the project staff made apresentation of its research into the current practice of reporting functional and naturelines in the performance statement as well as considering how to disaggregate func-tional lines into certain nature components. This project is still in its infancy is will takeseveral years to reach conclusion.

STUDY QUESTIONS

3. Which of the following is not a category or subcategory of financial statementsproposed under the financial performance reporting project?

a. Business section

b. Financing section

c. Income taxes section

d. Debt section

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4. Which of the following is the FASB proposing would be the category of cash on thestatement of cash flows?

a. Cash equivalents

b. Cash and cash equivalents

c. Cash only

d. Cash and short-term investments

¶406 THE FOCUS ON CASH FLOW, WORKINGCAPITAL AND OTHER FINANCIAL MEASUREMENTSFurthering the scrutiny and mistrust of GAAP earnings, more analysts and investors arefocusing on cash flow, working capital, and other financial measurements instead ofaccrual basis income in evaluating a company’s financial performance. With the confu-sion over GAAP, third parties are focusing on other measures that they understand,such as cash flow.

Many analysts are using several key ratios and calculations that track cash flow andother financial measurements in relation to GAAP income. Those ratios and calculationsare:

• Free Cash Flow

• Working Capital Ratios and Measurements

• Core Earnings

Free Cash FlowFree cash flow has become an important performance measurement used by financialanalysts. Although the formula for free cash flow can vary, typically it is based on theratio of free cash flow to common equity.

Free cash flow is just that—the amount of cash flow that is free for commonshareholders after accounting for fixed commitments such as capital expenditures andpreferred stock dividends.

The formula typically used for computing free cash flow is as follows:Free Cash Flow:

Net income: xx

Adjustments to reconcile net income to cash from operations:

Depreciation and amortization xx

Deferred income taxes xx

Gain/loss on sale of assets xx

Change in receivables xx

Change in inventories xx

Change in prepaid items xx

Change in accounts payable and accrued expenses xx

Net cash from operations (statement of cash flows) xx

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Less: Fixed items:

Capital expenditures (net of dispositions) (xx)

Preferred stock dividends (xx)

Free cash flow xx

Free cash flow can be further adjusted to reflect certain non-recurring items suchas cash paid for acquisitions (net of cash received from divestitures), and restructuringand severance costs. Some companies and third parties shift certain items that areincluded in the operating activities of the statement of cash flows to investing orfinancing activities, and vice versa.

Although more third parties and analysts are focusing on cash flow as a measure-ment that is equally important to GAAP accrual basis income, what is becoming clear isthat there are no standards for computing cash flow. In fact, GAAP does not define anyformulas for computing cash flow except those presented in the statement of cash flowsby ASC 230, Statement of Cash Flows, such as those categorized in the operating,investing, and financing activities sections, along with cash from operations. Therefore,concepts such as free or adjusted free cash flow and other cash flow variations willcontinue to be subject to alteration and manipulation until standards are adopted by theFASB, SEC, or others.

Free cash flow and non-cash investing and financial activitiesIn computing free cash flow, a deduction is made for property, plant, and equipmentwhich are fixed obligations that must be incurred to feed continued growth. However,problems exist in calculating free cash flow when an entity has non-cash purchases ofcapital assets that are not displayed on the statement of cash flows. As a result, thesenon-cash items are typically not adjusted in arriving at free cash flows, thereby dis-torting the resulting free cash flow amount.

ASC 230, Statement of Cash Flows, requires that non-cash investing and financialactivities be excluded from the statement of cash flows and, instead, be disclosed.

Examples of typical non-cash include:

• Purchase of equipment by issuance of a note

• Establishment of capital leases

• Conversion of debt to equity

In these transactions, no immediate cash is expended even though the entity isobligated under the transactions.

Companies can “play games� in increasing their free cash flow simply by changingthe way in which they make capital expenditures.

EXAMPLE: Company X has the following statement of cash flows:Cash flow from operating activities $2,000,000

Cash flow from investing activities:

Capital expenditures (3,000,000)

Cash flow from financing activities 3,000,000

Increase in cash and cash equivalents $2,000,000

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Free cash flow:

Cash flow from operating activities $2,000,000

Capital expenditures (3,000,000)

Free cash flow $(1,000,000)

Because the $3 million of capital expenditures was made in cash and presented onthe statement of cash flows, the capital expenditures are deducted in computing freecash flow.

Change the facts: Assume the company purchases the capital expenditures with debt.


Cash flow from investing activities:

Capital expenditures ( 0)

Cash flow from financing activities 3,000,000

Increase in cash and cash equivalents $5,000,000

Supplementary disclosure:

Company purchased $3,000,000 of equipment under a long-term debt obligation.

Free cash flow:


Capital expenditures ( 0)

Free cash flow $2,000,000

Conclusion: Free cash flow increases from $(1 million) to $2 million and does notreflect the non-cash capital expenditures of $3 million.

Note further that when the $3 million of debt related to the capital expenditure ispaid down, the principal payments are shown in the financial activities section and donot impact the free cash flow computation. Thus, no part of the non-cash transactionimpacts free cash flow.

OBSERVATION: The previous analysis exposes the loophole that existswhen an entity finances its capital expenditures. Under ASC 230, the expendituresare treated as a non-cash transaction which is disclosed and not presented in thebody of the statement of cash flows. In disclosing the non-cash transaction, thecapital expenditure is not deducted in computing free cash flow. Moreover, whenthe debt is repaid over time, the cash paid toward principal payments will bepresented in the financing activities section and has no impact on free cash flow.The result is that none of the cash associated with the purchase of the capitalexpenditures is deducted in computing free cash flow. In the previous example,none of the $3,000,000 of capital expenditures ever impacts free cash flow.

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Does it matter what type of non-cash capital expenditure transactionis made?There is a difference between how a capital expenditure is financed and its impact onfree cash flow.

Consider the following three transactions:

• Equipment is purchased through accounts payable that is outstanding at yearend.

• Equipment is leased through a capital lease.

• Equipment is purchased through long-term debt.

Under all three transactions, the equipment purchased is presented as a supple-mentary non-cash disclosure and is not deducted in computing free cash flow. Thus,there is no fundamental difference on the front end of the transaction. However, theback end of the transactions differs profoundly.

When equipment is purchased through accounts payable, there is ultimately animpact on free cash flow. When the accounts payable is paid in the following period, thechange in accounts payable is an adjustment to cash from operating activities, therebyaffecting free cash flows. Thus, purchasing equipment with accounts payable does, infact, ultimately result in the cash flow impacting free cash flow.

As for equipment purchased with long-term debt, or leased through a capital lease,there is no impact on free cash flows. That is, the capital expenditure related to theequipment purchase never impacts free cash flow. The reason is because when thelong-term debt or capital lease obligation is repaid over time or in lump sum, therepayment is presented in the financing activities section of the statement of cash flowsand does not impact free cash flow.

Georgia Tech Financial Analysis Lab StudyA study was published by Georgia Tech Financial Analysis Lab entitled Non-cashInvesting and Financial Activities and Free Cash Flow. The purpose of this Study was toconsider the effect of companies that do not deduct non-cash capital expenditures incomputing free cash flow.

The result is summarized in the following chart:Free Cash Flow – Adjustments for Non-Cash Capital Expenditures

Free cash Non-cashOperating Capital flows, as capital Adjusted % change

Company cash flows expend. reported Expend* FCF in FCF

Safeway $1,609,000 $(795,000) $814,000 $(113,000) $701,000 (14%)

Williams-Sonoma 209,000 (211,000) (2,000) (1,000) (3,000) (50%)

Albertson’s 1,545,000 (1,022,000) 523,000 $(62,000) 461,000 (12%)

Pathmark Stores 90,000 (51,000) 39,000 (10,000) 29,000 (26%)

Maxwell Tech 150,000 (95,000) 55,000 (18,000) 37,000 (33%)

Flowers Foods 88,000 (44,000) 44,000 (55,000) (11,000) (125%)

BJ’s Wholesale 200,000 (177,000) 23,000 (4,000) 19,000 (17%)

Plastipak Holdings 75,000 (99,000) (24,000) (7,000) (31,000) (29%)

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Free Cash Flow – Adjustments for Non-Cash Capital Expenditures

Free cash Non-cashOperating Capital flows, as capital Adjusted % change

Company cash flows expend. reported Expend* FCF in FCF

* Non-cash expenditures presented as supplementary disclosure and not presented on the face of thestatement of cash flows.

Source: Non-cash Investing and Financing Activities and Free Cash Flow, Georgia Tech College ofManagement, as modified by the author.

The Study illustrates that many companies are distorting their published free cashflows by not reflecting non-cash capital expenditures in the computation of free cashflows. For example, Safeway’s operating cash flows are $1,609,000 while adjusted freecash flow (FCF) is only $701,000.

Because free cash flow is not based on GAAP income, no standards exist thatrequire companies to adjust their free cash flow to include the adjustment for non-cashcapital expenditures.

Free cash flow and incentive compensationDue to the increase in the importance of free cash flow in analyzing financial perform-ance, some companies tie their incentive compensation plans into free cash flow.

Most valuation models suggest that an increase in free cash flow ultimatelytranslates directly into increases in stock price. Consequently, linking compensationplans to free cash flow is essentially the same as providing a nexus between income andcompensation.

The following companies are a sample of those that have reflected free cash flowinto their incentive compensation calculations:Company Basis for compensation plan

American Standards Sales, earnings, free cash flow, etc.

Bausch & Lomb Sales, earnings, free cash flow, etc.

Kraft Foods Income growth, volume growth, free cash flow, etc.

Motorola Operating earnings and free cash flow

Tyco EBIT and segment free cash flow

Source: Free Cash Flow and Compensation: A Fashionable Fad or Something More? Georgia TechCollege of Management.

Other companies, such as Newell, Washington Post, Weyerhauser, General Elec-tric, and Comcast, included some form of cash flow in their incentive compensationformulas, but did not specifically mention free cash flow.

Working CapitalAll working capital ultimately leads to cash. In evaluating cash flow of a company, it isimportant to look at the flow of individual working capital components, namely tradereceivables, inventories, and trade payables.

Four key ratios provide a thorough analysis of working capital. They are:

Days Sales in Accounts Receivable = Trade receivables* X 365

Net sales

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Days Supply in Inventory = Inventory* X 365

Cost of goods sold**

Days Payables Outstanding = Accounts payable* X 365

Cost of goods sold**

Days in Working Capital = AR + Inventory – AP* X 365

Net sales

* Average numbers can also be used (beginning + ending balances/2).

** Purchases can also be used in place of cost of goods sold.

*** Another variation is to include purchases and cash operating expenses in the denominator.

Each of these above working capital ratios should be compared with the bestpossible ratio.

EXAMPLE: If credit terms to customers are 30 days, and the number of days’sales in receivables is 49 days, there is a 19-day spread between the best possibleratio (30 days) and the actual ratio (49 days).

How important is working capital to analysts and investors in theirevaluation of a company?The cost of tying up cash due to ineffective working capital management can besignificant. Because working capital flow ultimately leads to cash flow, analysts paygreat attention to it as a measure of financial performance. In turn, companies areresponding by increasing their focus on working capital management, particularly atyear-end.

A study performed by REL Consulting Group that was published by CFO Magazinesuggests that:

• Working capital is so important to third-party financial statement users thatcompanies have stepped up their effort to manage their working capital at yearend through window dressing.

• One of the easiest ways to improve cash flow is to reduce the number of days innet working capital.

In the Study, REL performed working capital analysis on numerous companies inthe fourth quarter versus the following first quarter of the past three years to determineif there was manipulation of working capital at year end.

The results were as follows:

• There is a widespread pattern across industries that net working capital dropsdramatically in the fourth quarter of the fiscal year, and dramatically increases inthe following first quarter once the annual report has been published.

• U.S. companies tend to leave too much “housekeeping� of their working capitalto year end in terms of writing off bad debts and discarding obsolete inventory.

• Companies continue to reward executives based on operating income and notworking capital management. The interest cost of holding excess workingcapital is not reflected in operating income.

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OBSERVATION: The result of the survey suggests that management takesactions to reduce its working capital position at year end to maximize its cashposition. Once year-end financial statements are issued, net working capital in-creases back to its normal level.

2015 REL Consulting Group StudyIn 2015, a study on working capital (2015 U.S. Working Capital Survey, REL Consulting(The Hackett Group)) was published that assessed the working capital performance ofthe largest 967 U S. companies (based on sales) during the years 2005 to 2014. (2015information has not been published.) The Study concludes that U.S. companies’ work-ing capital position is flat at about 33 days of working capital outstanding. There is about$1 trillion of excess working capital, which is defined as nothing more than excess cashtied up in working capital due to inefficiency in working capital management. (Forpurposes of the study, net working capital is defined as trade receivables plus inventoryless trade payables.)

Following is a summary of the change in working capital from 2013 to 2014 (2015data was not available at the time of publication):2014 results: Change in[967 Largest U.S. Companies] 2014 2013 net WC % change

Days in receivables 36 36 (0)

Days in inventory 43 43 (0)

Days in payables (46) (46) (0)

Days in net working capital 33 33 (0) 0%

% change 2014 vs. 2013 0%

% change 2013 vs. 2012 0%

% change 2012 vs. 2011 (3.0%)

% change 2011 vs. 2010 (3.0%)

% change 2010 vs. 2009 (3.0%)

% change 2009 vs. 2008 8.0%

% change 2008 vs. 2007 (6.0%)

% change 2007 vs. 2006 (1.0%)

% change 2006 vs. 2005 (2.0%)

Specific conclusions reached by the study include (2015 U.S. Working CapitalSurvey, REL Consulting (The Hackett Group):

• Companies are cash rich with cash positions increasing by 74 percent from 2013to 2014 to an aggregate cash balance of about $932 billion.

• The ability to raise cash through cheap debt has reduced companies’ incentiveto release cash tied up in working capital. At the end of 2014, the top 967 U. S.companies had $1 trillion unnecessarily tied up in excess working capital,representing about six percent of U.S. GDP.

• Days in working capital hovering between 39 and 33 days from 2009 to 2014.

NOTE: In 2008, at the peak of the economy before the downturn, thenumber of days in net working capital was 35 days. From 2008 to 2010, net

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working capital increased significantly due primarily to the poor economy.In 2011 through 2014, the number of days in working capital became stableand ultimately settled at 33 days at the end of 2014.

• Days in working capital improved slightly declining from 38 days in 2010 to 33 in2014.

Prior to 2009, there had been continued effort by U.S. companies to reduce networking capital by implementing efficient systems to manage their working capital. Inparticular, there had been improvement in managing inventory as companies no longerstock piled inventories and were able to better match inventory supplies with productdemand due to efficiencies in the supply chain. When the U.S. economy declined, thoseentities were able to effectively shave their inventory supply down to match lowerdemand. A similar situation occurred with manufacturing labor whereby entities wereable to better match their labor supply with manufacturing demand. In doing so, therewas little “fat� existing in the manufacturing labor resulting in a challenge for thosesame companies to find further cuts in their manufacturing labor. In essence, during thestrong economic years of the early-to-mid 2000s, those entities had already imple-mented efficient cost cuts to the extent that there was no significant room forimprovement.

To no surprise, with the deteriorated economy in 2009, the number of days’ sales inreceivables increased from 35 days in 2008 to 39 in 2009, and ultimately came down andleveled off at 36 days in 2014. Once published, 2015 days sales in receivables is expectedto be the same as 2014.

Another interesting statistic is that the top 1,000 U.S. companies continue to havecash tied up in excess working capital which was estimated at $1 trillion at the end of2014. This excess working capital curtails companies from being able to expand andrequires them to seek liquidity from outside sources. This cost of inefficient workingcapital is significant. Consider the cost of capital required to replace $1 trillion of excessworking capital.

Given the tight financial markets, companies need to manage their working capitalas they must gather additional net cash to subsidize the potential financing shortfall.With financing difficult to obtain or expand, the least expensive and available alternativeis to squeeze the missing portion of required financing out of net working capital byreducing inventories, coercing or incentivizing customers to pay earlier, and by stretch-ing payables.

Measuring Collections of ReceivablesHistorically, companies have used the number of days sales outstanding (DSO) as theprimary gauge of credit-collection efficiency in connection with trade receivables.

As a reminder, DSO is calculated as follows:Days Sales in Accounts Last three months endingReceivable = total trade receivables X 30

Net sales for the quarter

Although DSO is typically useful in following trends in collections, it is notnecessarily the only measure that should be used. In particular, it is effective to look atboth DSO and average days delinquent (ADD). ADD reflects the average number ofdays’ invoices that are past due and is based on the following formula:

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ADD = DSO – Best Possible DSO

Best Possible DSO expresses the best possible level of receivables under the mostfavorable conditions, with no delinquencies.Best possible days sales Last three months endingoutstanding in accounts current portion of tradereceivable (BPDSO) = receivables X 30

Net sales for the quarter

EXAMPLE 1: Assume the following facts:

DSO = 45 days

Best possible DSO = 35 days

ADD = 45- 35 = 10 days

The ADD result means that customers were on average 10 days past due ontheir receivable balances.

EXAMPLE 2: Assume the following facts:

At December 31, 20X1, accounts receivable consists of the following:AR at December Three-month

31, 20X1: October 31 November 30 December 31 Total

Current $700,000 $650,000 $750,000 $2,100,000

31-60 200,000 150,000 100,000 450,000

61-90 125,000 75,000 100,000 300,000

More than 90 60,000 50,000 40,000 150,000

$1,085,000 $925,000 $990,000 $3,000,000

Net sales are $2 million for the fourth quarter 20X1.DSO = 1,085,000 + 925,000 + 990,000 X 30 = 45 days

2,000,000

DSO =45 daysBest possible DSO = 700,000 + 650,000 + 750,000 X 30 = 32 days

2,000,000

Best possible DSO = 32 daysDSO 45

32Best possible DSO

13Average days delinquent (ADD)

Conclusion: The ADD is 13 days which means that customers were 13 days late onpaying their receivables.

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DSO and ADD can move in different directionsThere are instances in which DSO and ADD can move in different directions forreasons other than efficiency of collections.

EXAMPLE: Assume the following:20X1 20X2

DSO 45 42

35 30Best possible DSO

10 12ADD

Conclusion: This is an example where DSO declines while ADD increases. Whenthis occurs, the decline in DSO is likely to be due to factors other than collectionefficiency.

The fact that the Best Possible DSO declined may be a result of several factors notrelated to collection efficiency such as:

• Changes in the receivable terms from net 35 to net 30

• Instituting an effective discount program such as changing from one percent totwo percent discount in 10 days

• Eliminating confusion and smoothing order processing procedures to shortenthe receivables cycle

• Tightening up sales personnel’s willingness to extend payment terms to specialcustomers

• Adopting stricter policies for receivable payment given up front as a result ofchanges from Sarbanes-Oxley

In this example, the company’s collection efforts have actually deteriorated from20X1 to 20X2 even though DSO has declined from 45 to 42 days. The benchmark forperfect collections is Best Possible DSO which has declined from 35 to 30 days due to achange in the payment terms from net 35 to net 30. Thus, one would expect that DSOwould decline by at least five days (from 45 to 40) just to retain the same level ofcollection quality in 20X2 versus 20X1. Yet this result did not occur as DSO declined byonly three days (45 to 42 days) and ADD increased from 10 to 12 days.

OBSERVATION: Because most companies and their accountants and audi-tors typically use DSO as the only benchmark for collection efficiency, they arelooking at a result that does not benchmark DSO against Best Possible DSO.Failure to do so means that a company’s collection efficiency may actually bedeteriorating even though DSO is declining. It is important that companies startusing DSO and ADD in evaluating receivables collections.

What is the Financial Cost of Having ADD?Average Days Delinquent (ADD) means there is capital tied up in receivable balancesand a related carrying cost thereto. To assist employees in understanding the costassociated with having too high of an ADD, a company can translate the cost into a lostopportunity cost as follows:

EXAMPLE: Company X has the following monthly receivables informationfor 20X9:

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AR % ADD/ ADD portion ofMonth Balance DSO Best DSO* ADD DSO AR

(A) (B) (A x B)

January 1 $4,000,000 42 27 15 36% $1,429,000

January 31 4,200,000 44 29 15 34% 1,431,000

February 28 4,400,000 46 30 16 35% 1,530,000

March 31 4,500,000 45 29 14 31% 1,400,000

April 30 4,400,000 41 28 13 32% 1,395,000

May 31 4,500,000 39 27 12 31% 1,385,000

June 30 4,700,000 46 29 17 37% 1,737,000

July 31 4,900,000 48 30 18 38% 1,838,000

August 31 3,800,000 45 29 16 36% 1,351,000

September 30 4,300,000 43 28 15 35% 1,500,000

October 31 4,100,000 42 28 14 33% 1,367,000

November 30 3,900,000 39 26 13 33% 1,300,000

December 31 4,200,000 41 27 14 34% 1,434,000

$4,300,000 $1,469,000Average

* Number of days in Best DSO is computed using the current portion of receivables off themonth’s AR aging. Typically, Best DSO will be less than the net terms (e.g., 30 days) due toincentive discounts such 2/10, net 30.

Assume further that the Company borrows on its working capital line of creditat an average rate of five percent in 20X9.

Conclusion: On average, the Company has $1,469,000 of excess receivablesoutstanding which represents that portion of receivables (ADD) in excess of thebest possible balance outstanding. The result is that the excess receivables of$1,469,000 costs the company the following in additional interest costs for 20X9.

$1,469,000 x 5% = $73,450 additional interest cost

OBSERVATION: Obviously, no company can achieve the Best Possible DSOlevel of receivables. Therefore, a company can build in a tolerable error that isgiven to the collections department and by which its performance is evaluated suchas the following:

Acceptable receivables level

Best possible DSO:

Net 30 terms 30

(2)Effect of discounts

Best possible DSO 28

7Acceptable ADD

35Acceptable DSO

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STUDY QUESTIONS

5. Which of the following does not ultimately impact free cash flow?

a. Collection of receivables

b. Purchasing equipment through long-term debt

c. Purchasing equipment with accounts payable outstanding at year end

d. Payment of preferred stock dividends

6. The following formula is entitled _________________:

a. Days supply in inventory

b. Days payable outstanding

c. Days in working capital

d. Days left in the sales cycle

7. One study indicated that at the end of 2014, U.S. companies ________________.

a. Had very little excess working capital

b. Had about $1 trillion tied up in excess working capital

c. Had fewer days outstanding in accounts payable versus accounts receivable

d. Had days in working capital increase from 2009 to 2014

¶407 WORKING CAPITAL MANAGEMENTAre There Signs that a Company has Poor Working CapitalManagement?A report entitled Improving Shareholder Value Through Total Working Capital, by RELConsulting Group, emphasizes the importance of working capital management and thefact that analysts and investors need to evaluate the working capital efficiencies of thecompanies in which they have an interest.

In the Report, REL identifies symptoms that exist in companies with poor workingcapital management techniques. The following chart identifies those symptoms:

Symptoms of Inefficiently Managed Working Capital

Trade receivables:

• Bad debts are increasing.

• Past due receivables (e.g., 90 days or older) are increasing.

• The company is unable to collect the majority of past due amounts due to customercomplaints.

• Customers are paying short due to quality issues.

• The company has imposed credit sanctions on its customers.

• The predictability of the company’s cash flow forecast is deteriorating.

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Symptoms of Inefficiently Managed Working Capital

• The company requires additional staff to process a backlog of unprocessed invoices.

• Receivables are growing disproportionately to sales.

• Receivables staff morale is deteriorating due to being overworked and making collectionscalls.

• The company has delays in closing the month-end due to billing problems.

• The company has month-end pressure to get as much sales and cash as possible.

• Number of days in payables is lower than the number of days in receivables.

Inventories:

• The company does not have detailed information of all inventories located at all points atthe same time.

• The company does not know the amount of its product that is being held by its top 10customers.

• The company does not know how much inventory it holds from its top 10 suppliers.

• Customer service levels are low.

• Sales and productions managers argue over product flexibility or availability.

• The company is increasing its “safety stocks� in response to unreliable sources of supplyand inter-company production.

• The warehouse is running out of space despite flat or lower sales.

• Inventory obsolescence and writeoffs are increasing.

• The company’s distribution network and its replenishment strategy have resulted instocking the same slow-moving items in various warehouses.

• Discontinued items clutter storerooms, warehouses, and the balance sheet.

Payables:

• Interest payments to suppliers are increasing.

• Payment disputes are increasing.

• The company has a payment run each day or quite frequently.

• The supplier list has expanded.

• The same supplier delivers to different sites based on different terms.

• There is no payment term “floor� that represents the minimum terms the purchasingdepartment should obtain.

• The company does not have an authorization procedure that demands approval for non-standard terms.

• Vendors have imposed credit sanctions on the company.

• Many of the non-cost-of-goods purchases are made outside the formal purchasing system.

• Purchase discounts have declined (emphasized)

Source: Improving Shareholder Value Through Total Working Capital ™ Management, RELConsultancy Group

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The Push Toward Holding Management Accountable for WorkingCapital ManagementThere is certainly a disconnect between profitability and working capital. Yet, the twoare quite interrelated. Efficient working capital management can significantly improvenot only cash flow but also profitability in several ways:

• Excess cash from efficient cash flow management can be used to pay down debtand, in turn, minimize interest expense.

• Efficient trade receivable collection procedures can minimize bad debts.• Efficient inventory management can reduce the amount of obsolescence.• Excess cash generated from trade receivable and inventory management can

allow a company to maximize purchase discounts.

Recently, companies have started considering cash flow/working capital manage-ment as a benchmark component used to compute management compensation.

One example is General Electric (GE) that uses performance share units (PSUs) tocompute equity compensation in lieu of stock options. GE executives are given PSUsthat vest in five years provided cash from operating activities increases at least 10percent per year during the five-year period. Thus, GE, like other companies, linkscompensation to cash/working capital management (Compensation and Cash Flow-CFO.com).

Some of the practices that companies can implement to create a long-term workingcapital management program include (U. S. Working Capital Survey, REL):

• Make cash flow improvement a strategic priority with visible senior manage-ment backing.

• Link cash flow performance and working capital management to compensationstructure.

• Make cash flow one of the key metrics for performance management withinoperations and finance.

• Focus on lead time compression and increasing manufacturing flexibility.• Standardize customer and supplier payment terms and control exceptions

through an escalation process.• Segregate customers and suppliers based on value and risk to support.• Automate and eliminate high-volume, low-margin transactions to free up

resources.

As suggested in the previous list of recommendations, cash flow and workingcapital management is becoming a key factor in compensation:

• More companies are using cash flow factors from the statement of cash flows toreward management rather than using only the statement of income.

• Many of the largest U.S.-based, publicly held companies use a cash-flow mea-surement to calculate short-term compensation, with the percentage continuingto rise.

• Cash flow/working capital management allows the company to focus on thebalance sheet rather than the income statement.

• Corporate boards are motivated to use cash flow because GAAP income, EPS,and revenue are subject to management’s manipulation.

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http://CFO.com


• With the FASB change to expensing stock options, companies have shied awayfrom stock options as a form of compensation.

• Some companies are using a blend of factors in their executive compensationbonus plans, such as 50 percent of bonuses based on the income statement and50 percent based on cash flow/working capital management.

Core EarningsAs a follow up to the FASB’s financial reporting project, Standard & Poor’s led the wayin publishing performance data on the S&P 500 using a benchmark other than netincome. More than one decade ago, Standard & Poor’s created a research project with agoal of developing a standard measurement that would most effectively measureoperating earnings, without the distortions on net income created by GAAP. The resultsof the research project were published in Measures of Corporate Earnings (Reportpublished by Standard & Poor’s).

The formula for core earnings used by S&P follows:Computation of the S&P’s Core Earnings (Measures of Corporate Earnings, Standard & Poor)

Net income $XX

Exclude:

Non-recurring items:

Discontinued operations XX

XXExtraordinary items

As reported income (used for EPS) XX

Exclude:

Goodwill impairment charges (1) XX

Gains/losses from asset sales (2) XX

Reversal of prior-year charges and provisions (5) XX

Merger/acquisition related expenses (2) XX

Litigation/insurance settlements and proceeds (2) XX

Include:

Employee stock option grant expense (3) (XX)

(XX)Pension costs (4)

Core earnings $XX

(1) Goodwill impairment charges are non-recurring items that do not result in the generation of periodrevenue.

(2) Non-recurring items are excluded from core earnings such as gains/losses from asset sales,merger and acquisition expenses, and litigation/insurance settlements and proceeds.

(3) Stock options expense is recorded using external fair value method, rather than intrinsic method.

(4) Pension costs on defined benefit plans are adjusted to compute cost based on actual investmentreturns instead of expected returns.

(5) There is a reversal into income of portions of restructuring charges and other provisions booked inprior periods.

Standard & Poor calculates and reports core earnings on U. S. equities, includingthe S&P 500.

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What is the impact of publishing core earnings for the S&P 500?In general, there continues to be a significant difference between reported GAAPoperating earnings per share and core EPS, with particular differences resulting fromstock options, pensions, and goodwill amortization.

Historically, the percentage of core EPS to operating EPS for the S&P 500 rangedfrom 80 to 92 percent from 2003 to 2015 (S&P published core earnings per share,2003-2015). Entities that have high quality earnings typically have a relatively highpercentage of core earnings to operating earnings, which is conclusive that most of theearnings are convertible into cash and not merely a function of manipulation of GAAP.Conversely, a ratio of a company’s core earnings to GAAP operating earnings that is lessthan 80 percent may indicate that the quality of earnings is poor and that GAAP incomeis not fully convertible into cash.

STUDY QUESTIONS

8. The REL report, Improving Shareholder Value Through Total Working Capital,identified what symptom that exists in companies with poor working capital manage-ment techniques?

a. Inventory obsolescence is decreasing.

b. Past due receivables are decreasing.

c. Suppliers deliver to other sites based on similar terms.

d. Vendors have imposed credit sanctions on the company.

9. How can working capital management significantly improve cash flow andprofitability?

a. Efficient accounts payable procedures can minimize bad debts.

b. Efficient inventory management can increase obsolescence.

c. Excess cash from efficient cash flow management can be used to establishmore accounts.

d. Excess cash generated can allow a company to maximize purchase discounts.

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89

MODULE 2: FINANCIAL STATEMENTREPORTING—CHAPTER 5: ConsolidationAnalysis

¶501 WELCOMEThis chapter provides an overview of the consolidation guidance prescribed within ASC810 along with the significant amendments to the guidance from ASU 2015-02. Thisincludes an in-depth analysis of five specific areas where ASU 2015-02 made specificamendments to the consolidations guidance along with illustrative examples.



• Recognize a key aspect of a VIE

• Recall situations in which use of combined statements is useful and not useful

• Identify when a limited partner has a controlling financial interest in a limitedpartnership under the voting interest model per ASU 2015-02

• Recognize a key change to the consolidation model made by ASU 2015-02 withrespect to a general partner of a limited partnership

• Identify some of the rights a noncontrolling limited partner might have in alimited partnership

¶503 INTRODUCTIONThe objective of ASU 2015-02, issued in February 2015, is to provide guidance as to theaccounting for consolidation of certain legal entities. The amendments are effective forpublic business entities for fiscal years, and for interim periods within those fiscal years,beginning after December 15, 2015. For all other entities, the ASU is effective for fiscalyears beginning after December 15, 2016, and for interim periods within fiscal yearsbeginning after December 15, 2017. Early adoption is permitted, including adoption inan interim period.

¶504 OVERVIEW OF EXISTING GAAP RULES FORINVESTMENTS AND CONSOLIDATIONSThis section summarizes the existing (pre-ASU 2015-02) general accounting rules forinvestments and consolidations. The accounting for investments is generally based onthe percentage ownership of the voting interest that one entity holds in another entity.The three tiers of ownership and the accounting rules related to each are summarizedas follows:

¶504


Ownership level General accounting treatment

1. Ownership of less than 20 percent of Investment recorded at cost or fair value depending onthe voting shares whether the investment is a security or non-security

2. Ownership of 20-50 percent of the Use the equity methodvoting shares or when one entity hassignificant influence over another entity

3. Ownership of more than 50 percent of Consolidate the entities (controlling financial interest)the voting shares

In addition to the above, the following chart summarizes the accounting treatmentin greater detail for all three tiers.

GAAP for Investments

Ownership of voting stock Accounting Treatment

TIER 1: Less than 20 percent ownership (In January 2016, the FASB issued ASU 2016-01,Financial Instruments—Overall (Subtopic 825-10) Recognition and Measurement of Financial Assetsand Financial Liabilities, which changes the accounting for certain equity investments. The ASU iseffective for 2018 for public entities, and 2019 for non-public entities. The changes made in ASU2016-01 are not reflected in this chapter due to the delayed effective date.)

a. Non-securities—closely held ASC 210 — Investments recorded at amortized cost. Ainvestments write-down is made to lower of cost or fair value if a

loss is other than temporary (permanent)

b. Securities- debt or equity- placed ASC 320 — Securities are recorded at fair value or costinto three categories: based on three investment categories:

1. Held to maturity securities— Recorded atamortized cost

2. Trading securities— Recorded at fair value—gain/loss presented on the income statement

3. Available-for-sale securities— Recorded at fairvalue-gain/loss presented in stockholders’equity, net of taxes (other comprehensiveincome)

TIER 2: 20-50 percent or significantinfluence ASC 323–Use the equity method

TIER 3: Consolidation or Combined Financial Statements

a. Consolidation based on more than 50 ASC 810—Consolidate in all casespercent ownership of voting stock

b. Exceptions where consolidation is Four exceptions to the more than-50-percentbased on other than ownership consolidation rules—Consolidate even if more-than-50

percent ownership threshold is not met:

[controlling financial interest] 1. Entities controlled by contract

2. General partner that controls a limitedpartnership

3. Miscellaneous transactions involving researchand development arrangements and rabbi trusts

4. Variable interest entities (VIEs)

c. Combined financial statements Option to combine financial statements of two or moreentities when it is more meaningful to do so.

¶504

91MODULE 2 - CHAPTER 5 - Consolidation Analysis

Following this section, this chapter author focuses only on Tier 3 of the ownershiphierarchy, involving consolidation.

¶505 CONSOLIDATIONS AND COMBINEDSTATEMENTSThe overall rules for consolidations are found in ASC 810, Consolidation. ASC 810 statesthat “there is a presumption that consolidated statements are more meaningful thanseparate statements . . . � In general, ASC 810 requires the consolidation of all majority-owned subsidiaries; that is, a situation in which one entity has a controlling financialinterest (through ownership of more than 50 percent voting shares) in another entity.

Exceptions to the CHAPTER More Than-50-Percent Ownership TestUnder existing GAAP (pre ASU 2015-02), the general rule is that consolidation isrequired when one entity has a controlling financial interest in another entity throughowning more than 50 percent of that entity’s voting stock. For tax purposes, consolida-tion generally occurs when an 80 percent or more ownership threshold is met. Althoughmore-than-50 percent ownership is the minimum threshold for consolidation, existingGAAP provides four exceptions as noted in the table above. In such cases, an entity hasa controlling financial interest through other than ownership.

Exception 1: Entities Controlled by ContractASC 810-10-15 provides an exception to the more-than-50 percent ownership threshold.Specifically, there are situations in which one entity controls another through a contrac-tual management agreement without having ownership of a majority of the outstandingvoting equity. The most common example of this arrangement is found in the medicalfield in which a physician practice (PP) engages in a contract with a physician practicemanagement entity (PPME) for the PPME to manage the PP. In such cases, it is typicalfor the PPME to control the PP but have no ownership in the practice. In suchcircumstances, the PPME should consolidate with the physician’s practice.

In particular, ASC 810-10-15 applies to contractual management arrangements withboth of the following characteristics:

• Relationships between more than one physician practices (PP) that operate inthe health care industry including the practices of medicine, dentistry, veteri-nary science, and chiropractic medicine

• Relationships in which the PPME does not own the majority of the outstandingvoting equity of the physician practices either because the PPME is precludedby law from owning the equity, or because the PPME has elected not to own theequity

If the following criteria are met, the PPME has a controlling financial interest in thePP and should consolidate the PP:

1. The contractual arrangement a) has a term that is either the entire remaininglegal life of the physician practice entity or a period of 10 years or more, and b)is not terminable by the physician practice except in cases of gross negligence,fraud, other illegal acts, or bankruptcy by the PPME.

2. The PPME has exclusive authority over all decision making involving thepractice operations and compensation of the medical professionals.

3. The PPME must have a significant (but not necessarily majority) financialinterest in the physician practice that meets certain criteria.

¶505


COMMENT: ASC 810-10-15 states that the guidance for entities controlledcan be used in other industries and similar circumstances. The conclusion sug-gests that in other circumstances in which control is determined by a contractother than ownership, entities may consolidate. However, the guidance should notbe taken out of context. Because ASC 810-10-15 gives no examples of wherecircumstances would be considered “similar,� it may not be prudent to apply acontrol standard that is measured on other-than majority ownership (e.g., morethan 50 percent ownership).

Exception 2: General Partner in a Limited PartnershipASC 810 applies to general partners in limited partnerships or similar entities (such aslimited liability companies that have governing provisions that are the functionalequivalent of a limited partnership) that are not variable interest entities (VIEs) underFIN 46R. The general rules follow:

• A general partner (GP) that controls a limited partnership should consolidatethe partnership into its financial statements.

• There is a presumption that general partners control a limited partnershipregardless of the extent of the general partners’ ownership interest in thelimited partnership.

• The presumption that general partners control a partnership is overcome (thegeneral partners do not control the limited partnership) if the limited partnershave either:

- Substantive kick-out rights: The substantive ability to dissolve (liquidate) thelimited partnership or otherwise remove the general partners without cause

- Substantive participating rights: The ability to effectively participate in certainactions of the limited partnership

COMMENT: Protective rights that would allow the limited partners to blockpartnership actions (e.g., amendments to the agreement, pricing on transactions,liquidation of the partnership, or acquisitions and dispositions of assets) would beconsidered protective (rather than participating) rights and would not overcomethe presumption of control by the general partners. A limited partner’s unilateralright to withdraw from the partnership in whole or in part (withdrawal right) thatdoes not require dissolution or liquidation of the entire limited partnership wouldnot overcome the presumption that the general partners control the limitedpartnership.

EXAMPLE: Assume that a general partner (GP Corp) controls a real estate limitedpartnership, yet owns only one percent of the limited partnership. The remaining 99percent is owned by the limited partners who have minimal control over the limitedpartnership. Further, there are no restrictions on the general partner and the limitedpartners do not have the right to remove the general partner unless there is provenfraud.

¶505


The ownership structure looks like this:

Conclusion

Under existing GAAP, the GP would consolidate with the limited partnership eventhough it has only one percent ownership. This conclusion is based on the fact that thegeneral partner controls the partnership with minimal restrictions on that control.

However, consider if the partnership agreement restricts certain rights of thegeneral partner by giving those rights to the limited partners. Those restrictive rightsinclude the right to replace the general partner by a super-majority vote, approvalrequired for the sale of assets, and refinancing or acquisition of principal assets. In thissituation, because the general partner’s control is restricted by additional rights given tothe limited partners, the general partner would not consolidate with the limitedpartnership.

Exception 3: Miscellaneous Transactions Involving Research andDevelopment Arrangements and Rabbi TrustsAnother exception under which an entity should consolidate another entity even thoughthere is no majority ownership among the entities is in the case where there is aresearch and development arrangement among the entities. The other is in circum-stances in which an employer should consolidate into its financial statements theaccounts of a Rabbi Trust.

Exception 4: The Variable Interest Entity Rules-FIN 46RUnder existing GAAP, the fourth exception to the more-than-50 percent-ownership rulefor consolidation is where there is an off-balance-sheet entity that is categorized as avariable interest entity (VIE) as discussed in FASB Interpretation No. 46R, Consolida-tion of Variable Interest Entities—An Interpretation of ARB No. 51, now part of ASC810, Consolidation. FIN 46R requires a primary beneficiary to consolidate a VIE. Ingeneral, a VIE is an entity that is not self-supportive. An entity is considered a VIE if, bydesign (FIN 46R states that the phrase “by design� refers to entities that meet theconditions of being a VIE because of the way they are structured. For example, an entityunder the control of its equity holders that originally was not a VIE does not becomeone because of operating losses), it has one or both of the following two conditions:

1. The total equity investment at risk is not sufficient to permit it to finance itsactivities without obtaining additional subordinated financial support providedby any parties (e.g., individual or entity), including equity holders.

¶505


2. As a group, the holders of equity investments at risk lack any one of thefollowing three characteristics:

• Lack the power through voting rights or similar rights to direct the entity’sactivities that most significantly impact the entity’s economic performance

• Lack the obligation to absorb the expected losses of the entity

• Lack the right to receive expected residual returns of the entity.

A VIE is consolidated by a primary beneficiary entity if that entity has a controllingfinancial interest in the VIE model through having both of the following:

a. The power to direct the activities that most significantly impact the VIE’seconomic performance

b. The obligation to absorb losses of the VIE that could potentially be significantto the VIE or the right to receive benefits from the VIE that could potentially besignificant to the VIE

EXAMPLE: Harry owns 100 percent of companies A and B, yet there is nodirect ownership between A and B. A sells 25 percent of its product to B but thereis no indication of control or financial support between A and B. The two entitiesare not required to be consolidated under the VIE rules of FIN 46R. Becauseconsolidation is not required for the two entities, the entities may elect to issuecombined financial statements.

EXAMPLE: Harry owns 100 percent of Company A. Company A rents the realestate used in its operations from Company B, which is an LLC, solely owned byHarry. The two entities are not required to be consolidated under FIN 46R.Because consolidation is not required, issuing combined financial statements is anoption and may be more meaningful.

Combined financial statements are never required, but may be useful in certaincases. Combining is treated essentially in the same manner as a consolidation with allintercompany transactions eliminated. Although there are similarities, combined finan-cial statements differ from consolidated financial statements in two ways:

• Stockholders’ equity is combined, not eliminated, because there is no invest-ment to eliminate.

• The report must be altered to reflect the combined entities.

VIE Exemption for Private Companies in Common Control LeasingArrangementsIn March 2014, the Private Company Council (PCC) issued, and the FASB endorsed,ASU 2014-07: Consolidation (Topic 810): Applying Variable Interest Entities Guidance toCommon Control Leasing Arrangements-A consensus of the Private Company Council. ThisASU provides a private company exemption from consolidation under FIN 46R VIErules.

The general provisions of ASU 2014-07 are summarized as follows:

a. A private company lessee (the reporting entity) may elect an accountingalternative not to apply the FIN 46R VIE guidance to a lessor entity (notconsolidate a real estate lessor) if four criteria are met:

• The private company lessee and the lessor entity are under common control.

• The private company lessee has a lease arrangement with the lessor entity.

¶505


• Substantially all of the activities between the private company lessee and thelessor entity are related to leasing activities (including supporting leasingactivities) between those two entities.

• If the private company lessee explicitly guarantees or provides collateral forany obligation of the lessor entity related to the asset leased by the privatecompany, the principal amount of the obligation at inception of the guaranteeor collateral arrangement does not exceed the value of the asset leased bythe private company from the lessor entity.

b. A private company lessee that elects the accounting alternative not to consoli-date the real estate lessor is required to expand certain disclosures.

It should be noted that the ASU 2014-07 exemption only applies to private companyleasing arrangements and does not exempt private companies from applying the VIEconsolidation rules to other non-leasing arrangements such as management contracts,etc.

¶506 ASU 2015-02 OVERVIEWThe FASB issued ASU 2015-02 to respond to stakeholders’ comments about the currentaccounting for consolidation of certain legal entities. Stakeholders expressed concernsthat current GAAP for consolidations required modifications. As a result, the FASBissued amendments in ASU 2015-02, which change the analysis that a reporting entitymust perform to determine whether it should consolidate certain types of legal entities.The table below provides an overview of the key changes from the ASU.Comparison of Consolidation Models Existing ASC 810 GAAP Versus Changes by ASU 2015-02 [GeneralRule: Consolidate if there is a controlling financial interest]

Existing GAAP- ASC 810 Changes to ASC 810 by ASU 2015-02

Voting interest entity model:

Consolidate based on ownership of No changemore than 50 percent of voting shares

VIE Model:

Variable interest entities Several changes involving:

• Fees paid to decision makers and serviceproviders

• Determination of the primary beneficiaryincluding related parties

Entities controlled by contract: No change

Physician Practice ManagementEntities (PPME)

General partner that controls a limited Changed under the voting interest entity model:partnership

• Presumption that GP consolidates LP iseliminated

• Rules changes to provide that investor withmajority of kick-out rights consolidates LP(voting interest entity model)

Miscellaneous transactions involving No changeR&D arrangements and Rabbi Trusts

¶506


The amendments in the ASU affect reporting entities that are required to evaluatewhether they should consolidate certain legal entities. All legal entities are subject toreevaluation under the revised consolidation model. Specifically, the amendments pre-scribe the following:

• Reduce the number of consolidation models by eliminating the special model forlimited partnerships.

• Modify the evaluation of whether limited partnerships and similar legal entitiesare VIEs or voting interest entities.

• Eliminate the presumption that a general partner should consolidate a limitedpartnership.

• Affect the consolidation analysis of reporting entities that are involved withVIEs, particularly those that have fee arrangements and related partyrelationships.

• Provide a scope exception from consolidation guidance for most money marketfunds; reporting entities with interests in legal entities that are required tocomply with or operate in accordance with requirements that are similar tothose in Rule 2a-7 of the Investment Company Act of 1940 for registered moneymarket funds.

Additionally, the amendments in ASU 2015-02 affect the following areas, each ofwhich is described in greater detail in the following sections:

• Limited partnerships and similar legal entities

• Evaluating fees paid to a decision maker or a service provider as a variableinterest

• The effect of fee arrangements on the primary beneficiary determination

• The effect of related parties on the primary beneficiary determination

• An exemption for certain investment funds

Limited Partnerships and Similar Legal EntitiesThe ASU changes three main provisions that affect the consolidation of limited partner-ships and similar legal entities, such as LLCs. This includes the following:

• There is an additional requirement that limited partnerships and similar legalentities must meet to qualify for consolidation as voting interest entities.

• A limited partnership must provide partners with either substantive kick-outrights or substantive participating rights over the general partner to meet thisrequirement.

• The specialized consolidation model and guidance for limited partnerships andsimilar legal entities have been eliminated.

• There is no longer a presumption that a general partner should consolidate alimited partnership.

• For limited partnerships and similar legal entities that qualify as voting interestentities, a limited partner with a controlling financial interest should consolidatea limited partnership.

• A controlling financial interest may be achieved through holding a limitedpartner interest that provides a majority of substantive kick-out rights.

¶506


Evaluating Fees Paid to a Decision Maker or a Service Provider as aVariable InterestIn the VIE model, a reporting entity must determine whether it has a variable interest inthe entity being evaluated for consolidation. Current GAAP provides six criteria thatmust be met in order for fees paid by a legal entity (VIE) to a decision maker or aservice provider not to be a variable interest in the legal entity. The ASU eliminatesthree of these six conditions for evaluating whether a fee paid to a decision maker or aservice provider represents a variable interest. If a reporting entity (decision maker orservice provider) fails any of the remaining three conditions, it has a variable interest ina VIE. Consequently, the reporting entity (decision maker or service provider) mustevaluate whether its variable interest represents a controlling financial interest in theVIE; that is, whether the reporting entity is the primary beneficiary that shouldconsolidate the VIE. Because only three conditions must be met for fees not to be avariable interest, the change is likely to result in fewer decision makers and serviceproviders consolidating VIEs.

The Effect of Fee Arrangements on the Primary BeneficiaryDeterminationUnder both current GAAP requirements and the amendments in ASU 2015-02, adecision maker is determined to be the primary beneficiary of a VIE if it satisfies boththe power and the economics criteria. As a result, the primary beneficiary consolidates aVIE because it has a controlling financial interest.

Under existing GAAP, if a fee arrangement paid to a decision maker, (such as anasset management fee), is determined to be a variable interest in a VIE (it fails the 6conditions), the decision maker must include the fee arrangement in its determinationas to whether it is the primary beneficiary analysis that consolidates the VIE. Conse-quently, the fees paid to the decision maker give considerable weight to concluding thatthe decision maker is the primary beneficiary. Under existing GAAP, the decisionmaker or service provider uses the fees it has received in performing the analysis as towhether the decision maker meets both the power criterion and economic criterion. Ifboth are satisfied, the decision maker or service provider is considered the primarybeneficiary and must consolidate the VIE.

The amendments in the ASU specify that some fees paid to a decision maker orservice provider are excluded from the evaluation of the economics criterion (secondcriterion) if the fees are both customary and commensurate with the level of effortrequired for the services provided. The ASU amendments make it less likely for adecision maker or service provider to meet the economics criterion solely on the basisof a fee arrangement. As a result, fewer decision makers and service providers will beconsidered a primary beneficiary and will not likely consolidate a VIE to which theyprovide services.

The Effect of Related Parties on the Primary BeneficiaryDeterminationIn instances in which no single party has a controlling financial interest in a VIE, currentGAAP requires interests held by a reporting entity’s related parties to be treated asthough they belong to the reporting entity when evaluating whether a related-partygroup has the characteristics of a primary beneficiary. The amendments in ASU 2015-02reduce the application of the related party guidance for VIEs on the basis of thefollowing three changes:

¶506


• For single decision makers, related party relationships must be consideredindirectly on a proportionate basis, rather than in their entirety.

• After the assessment above is performed, related party relationships should beconsidered in their entirety for entities that are under common control only ifthat common control group has the characteristics of a primary beneficiary.That is, the common control group collectively has a controlling financialinterest.

• If the second assessment is not applicable, but substantially all of the activities ofthe VIE are conducted on behalf of a single variable interest holder (excludingthe decision maker) in a related party group that has the characteristics of aprimary beneficiary, that single variable interest holder must consolidate theVIE as the primary beneficiary.

The ASU does not amend the related party guidance for situations in which poweris shared between two or more entities that hold variable interests in a VIE.

Exemption for Certain Investment FundsThe amendments in the ASU rescind the indefinite deferral of FASB Statement No. 167,Amendments to FASB Interpretation No. 46(R), included in FASB Accounting Stan-dards Update No. 2010-10, Consolidation (Topic 810): Amendments for Certain Invest-ment Funds. In addition, the amendments in the ASU provide a scope exception fromthe consolidation requirements for reporting entities with interests in legal entities thatare required to comply with or operate in accordance with requirements similar to thosein Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds.

STUDY QUESTIONS

1. If one entity has between 20-50 percent of the voting shares in another entity, what isthe general accounting treatment for the investment?

a. Consolidate the entities

b. Investment recorded at cost

c. Investment recorded at fair value

d. Use the equity method

2. The general rule for consolidation of entities found in ASC 810, Consolidation, is thatconsolidation occurs when:

a. One entity manages, but does not own, another entity.

b. One entity directly or indirectly has a controlling financial interest in anotherentity.

c. One entity owns less than 50 percent of the voting shares of another entity

d. There is an off-balance-sheet entity

3. Under GAAP in effect prior to ASU 2015-02, a general partner who controls a limitedpartnership should account for the limited partnership using which of the following?

a. By recording any investment that the GP has in the LP at amortized cost

b. By recording any investment that the GP has in the LP at fair value

c. By recording any investment that the GP has in the LP using the equitymethod

d. By consolidating the LP into the GP’s financial statements

¶506


4. Under which of the following situations would it make sense for an entity to combinefinancial statements with another entity?

a. An entity owns none of another entity’s voting stock. The entity has severaldifferent owners and no common ownership

b. An entity owns more than 50 percent of another entity’s voting stock

c. An off-balance-sheet entity is a VIE and meets certain criteria under FIN 46R

d. Two entities under common control that do not meet the criteria for consolida-tion under FIN 46R

5. Which of the following is a characteristic of an entity that is a VIE? The holders ofequity investments ________________:

a. Have the obligation to absorb the expected losses of the entity

b. Have the right to receive expected residual returns of the entity

c. Lack the power to direct the entity’s activities

d. Created the entity at inception

6. Company X is performing a primary beneficiary test on Company VIE to determinewhether X should consolidate VIE. In performing the test, how should X account forfees paid to X?

a. The fees paid are excluded if two conditions are met.

b. The fees are included in all instances.

c. The fees are excluded even if they expose the entity to risk of loss.

d. Fees paid to a service provider are not considered fees paid to a reportingentity.

¶507 ASU 2015-02 AMENDMENTSIn addition to the information presented above, the ASU also added several definitionsto the ASC Master Glossary. Each of these new definitions is described in detail below.

Kick-Out RightsWith respect to VIEs, this is the ability to remove the entity with the power to direct theactivities of a VIE that most significantly impact the VIE’s economic performance or todissolve (liquidate) the VIE without cause. Alternatively, for Voting Interest Entities,these are the rights underlying the limited partner’s or partners’ ability to dissolve(liquidate) the limited partnership or otherwise remove the general partners withoutcause.

Participating RightsWith respect to VIEs, this is the ability to block or participate in the actions throughwhich an entity exercises the power to direct the activities of a VIE that most signifi-cantly impact the VIE’s economic performance. Participating rights do not require theholders of such rights to have the ability to initiate actions. Alternatively, for VotingInterest Entities, these are the rights that allow the limited partners or non-controllingshareholders to block or participate in certain significant financial and operating deci-sions of the limited partnership or corporation that are made in the ordinary course ofbusiness. Participating rights do not require the holders of such rights to have theability to initiate actions.

¶507


Protective RightsFor VIEs, these are the rights designed to protect the interests of the party holdingthose rights without giving that party a controlling financial interest in the entity towhich they relate. For example, they include approval or veto rights granted to otherparties that do not affect the activities that most significantly impact the entity’seconomic performance, the ability to remove the reporting entity that has a controllingfinancial interest in the entity in circumstances such as bankruptcy or on breach ofcontract by that reporting entity, or limitations on the operating activities of an entity.For Voting Interest Entities, these are the rights that are only protective in nature andthat do not allow the limited partners or non-controlling shareholders to participate insignificant financial and operating decisions of the limited partnership or corporationthat are made in the ordinary course of business.

Decision MakerThis is an entity or entities with the power to direct the activities of another legal entitythat most significantly impact the legal entity’s economic performance according to theprovisions of the Variable Interest Entities Subsections of Subtopic 810-10.

Decision-Making AuthorityThis is the power to direct the activities of a legal entity that most significantly impactthe entity’s economic performance according to the provisions of the Variable InterestEntities Subsections of Subtopic 810-10.

Ordinary Course of BusinessThis includes decisions about matters of a type consistent with those normally expectedto be addressed in directing and carrying out current business activities, regardless ofwhether the events or transactions that would necessitate such decisions are expectedto occur in the near term. However, it must be at least reasonably possible that thoseevents or transactions that would necessitate such decisions will occur. The ordinarycourse of business does not include self-dealing transactions.

With CauseWith cause generally restricts the limited partners’ ability to dissolve (liquidate) thelimited partnership or remove the general partners in situations that include, but thatare not limited to, fraud, illegal acts, gross negligence, and bankruptcy of the generalpartners.

Without CauseWithout cause means that no reason need be given for the dissolution (liquidation) ofthe limited partnership or removal of the general partners.

¶508 CONSOLIDATION GUIDANCEThe general rule is that consolidation is required when one entity has a controllingfinancing interest in another entity. There are two primary models for determiningwhether one entity has a controlling financing interest in another entity. This includesthe voting interest model and the variable interest model. Also, additional analysis isrequired for consolidation of entities controlled by contract, and a carve-out exceptionfor R&D and miscellaneous other activities, which is applicable to entities that are notVIEs.

¶508


Voting Interest Entity ModelUnder the voting interest entity model, for legal entities other than limited partnerships,the usual condition for a controlling financial interest is ownership by one reportingentity, directly or indirectly, of more than 50 percent of the outstanding voting shares ofanother entity. For limited partnerships, the usual condition for a controlling financialinterest is ownership by one limited partner, directly or indirectly, of more than 50percent of the limited partnership’s kick-out rights through voting interests. However,there is one exception. If noncontrolling shareholders or limited partners have substan-tive participating rights, the majority shareholder or limited partner with a majority ofkick-out rights through voting interests does not have a controlling financial interestand would not consolidate the limited partnership.

VIE ModelIn the VIE model, a controlling financial interest is assessed differently than under thevoting interest entity model. This difference in assessment is required because acontrolling financial interest may be achieved other than by ownership of shares orvoting interests, like is the case with the voting interest model. Under the VIE model, acontrolling financial interest requires a reporting entity to have both the power to directthe activities that most significantly impact the VIE’s economic performance, and theobligation to absorb losses of the VIE that could potentially be significant to the VIE orthe right to receive benefits from the VIE that could potentially be significant to the VIE.A reporting entity with a controlling financial interest in a VIE is referred to as theprimary beneficiary.

COMMENT: The reporting entity could be, but is not limited to being, anequity investor, some other capital provider such as a debt holder, or a party withanother contractual arrangement such as a guarantor. This model applies to alltypes of legal entities.

¶509 KEY CHANGES MADE BY ASU 2015-02As previously noted, ASU 2015-02 amends ASC 810 to reflect five key changes dis-cussed further on in this chapter, as follows:

1. Limited partnerships and similar legal entities

2. Evaluating fees paid to a decision maker or a service provider as a variableinterest

3. The effect of fee arrangements on the primary beneficiary determination

4. The effect of related parties on the primary beneficiary determination

5. Certain investment funds

Each of the above changes is discussed in more significant detail in the followingsections.

¶510 CHANGE 1: LIMITED PARTNERSHIP INTERESTSAND SIMILAR LEGAL ENTITIESEXISTING GAAPA general partner that controls a limited partnership consolidates the partnership intoits financial statements. In addition, there is a presumption that general partners controla limited partnership regardless of the extent of the general partners’ ownershipinterest in the limited partnership. However, the presumption that general partnerscontrol a partnership is overcome (the general partners do not control the limited

¶510


partnership) if the limited partners have either substantive kick-out rights or substan-tive participating rights.

NEW RULES PER ASU 2015-02The ASU changes three main provisions that affect the consolidation of limited partner-ships and similar legal entities. This includes an additional requirement that limitedpartnerships and similar legal entities must meet to use the voting interest entity model.In addition, a limited partnership must provide partners with either substantive kick-outrights or substantive participating rights over the general partner to qualify for thevoting interest entity model.

Also, the specialized consolidation model and guidance for limited partnerships andsimilar legal entities has been eliminated. As a result, the ASU eliminates the presump-tion that a general partner should consolidate a limited partnership. In most instances, ageneral partner will not consolidate a limited partnership. However, under the newrules, a limited partnership is evaluated for consolidation using either the voting interestentity model or the VIE model. For limited partnerships and similar legal entities thatqualify as voting interest entities, a limited partner with a controlling financial interestshould consolidate a limited partnership. A single limited partner has a controllingfinancial interest if it holds a limited partner interest that provides more than 50 percentof the substantive kick-out rights.

COMMENT: A similar legal entity is an entity (such as a limited liabilitycompany) that has governing provisions that are the functional equivalent of alimited partnership. In such entities, a managing member is the functionalequivalent of a general partner, and a nonmanaging member is the functionalequivalent of a limited partner.

General Rule for Consolidation of a Limited Partnership – VotingInterest ModelUnder the voting interest entity model, the limited partnership must give its limitedpartners substantive kick-out rights or substantive participating rights over the generalpartner. If a limited partnership does not give its limited partners substantive kick-outrights or substantive participating rights, the limited partnership is evaluated forconsolidation using the VIE model (discussed later). In a limited partnership, kick-outrights, through voting interests, are the same as voting rights held by shareholders of acorporation. As a result, under the voting interest entity model, a single limited partnerconsolidates a limited partnership if all of the following are true:

• The single limited partner holds a controlling financial interest by holding morethan 50 percent of the limited partnership’s kick-out rights through votinginterests.

• The kick-out rights are substantive.

• Non-controlling limited partners do not have substantive participating rights thatblock the single limited partner’s kick-out rights.

In measuring whether a single limited partner holds more than 50 percent of thekick-out rights, the kick-out rights held by general partners through voting interests areignored. Under the new ASU rules, a general partner no longer consolidates the limitedpartnership under the voting interest entity model.

Kick-Out RightsFor limited partnerships, the determination of whether kick-out rights are substantive isbased on a consideration of all relevant facts and circumstances. For kick-out rights to

¶510


be considered substantive, the limited partners holding the kick-out rights must havethe ability to exercise those rights if they choose to do so; that is, there are nosignificant barriers to the exercise of the rights to either dissolve (liquidate) the limitedpartnership, or remove the general partners without cause. Barriers that may makekick-out rights less substantive include the following:

• Kick-out rights subject to conditions that make it unlikely they will be exercisa-ble, for example, conditions that narrowly limit the timing of the exercise

• Financial penalties or operational barriers associated with dissolving (liquidat-ing) the limited partnership or replacing the general partners that would act as asignificant disincentive for dissolution (liquidation) or removal

• The absence of an adequate number of qualified replacement general partnersor the lack of adequate compensation to attract a qualified replacement

• The absence of an explicit, reasonable mechanism in the limited partnership’sgoverning documents or in the applicable laws or regulations, by which thelimited partners holding the rights can call for and conduct a vote to exercisethose rights

• The inability of the limited partners holding the rights to obtain the informationnecessary to exercise them

Withdrawal RightsWithdrawal rights are the limited partners’ unilateral rights to withdraw from thepartnership in whole or in part that does not require dissolution or liquidation of theentire limited partnership.. The requirement to dissolve or liquidate the entire limitedpartnership upon the withdrawal of a limited partner shall not be required to becontractual for a withdrawal right to be considered as a potential kick-out right.

Rights held by limited partners to remove the general partner(s) from the partner-ship shall be evaluated as kick-out rights as appropriate. Additionally, rights of thelimited partners to participate in the termination of management (for example, manage-ment is outsourced to a party other than the general partner) or the individual membersof management of the limited partnership may be substantive participating rights.

General Rule for Consolidation of a Limited Partnership – VIE ModelA limited partnership is evaluated for consolidation under the VIE model if it does notqualify for the voting interest entity model because it is a VIE. An LP entity isconsidered a VIE if it meets the definition of a VIE (discussed earlier) and it does notprovide its limited partners with substantive kick-out rights or substantive participatingrights.

COMMENT: If a limited partnership does not provide its limited partners withsubstantive kick-out rights or substantive participating rights, then the holders ofequity investments (LPs) lack the power to direct the LP’s activities and the LP is aVIE.

As previously discussed, the party that consolidates the limited partnership iscalled the primary beneficiary, which is the party that has a controlling financial interestin the limited partnership through both power and benefits. Under the VIE model, ageneral partner might be considered the primary beneficiary that consolidates thelimited partnership (VIE). Under the voting interest model, the GP would not consoli-date an LP unless the GP owns more than 50 percent of the kick-out rights throughownership of the LP interest.

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Effect of Noncontrolling Rights on Consolidation of LimitedPartnerships

In some instances, the powers of a limited partner with a majority of kick-out rightsthrough voting interests to control the operations or assets of the investee are restrictedin certain respects by approval or veto rights granted to a limited partner (referred to asnoncontrolling rights). This does not apply to entities that, in accordance with GAAP,carry substantially all of their assets, including investments in controlled entities, at fairvalue with changes in value reported in a statement of net income or financial perform-ance, or investments in VIEs. Like many areas of GAAP, the assessment of whether therights of a noncontrolling limited partner should overcome the presumption of consoli-dation by the limited partner with a majority of kick-out rights in its investee is a matterof judgment that depends on facts and circumstances.

The determination is based on whether the noncontrolling rights, individually or inthe aggregate, allow the noncontrolling limited partner to effectively participate incertain significant financial and operating decisions of the investee that are made in theordinary course of business.

COMMENT: Effective participation means the ability to block significantdecisions proposed by the general partner or investor who has a majority votinginterest. When a noncontrolling limited partner has effective participation, controldoes not rest with the majority owner because the investor with the majority votinginterest cannot cause the investee to take an action that is significant in theordinary course of business if it has been vetoed by the noncontrollingshareholder.

For limited partnerships, control does not rest with the limited partner with themajority of kick-out rights if the limited partner cannot cause the general partner to takean action that is significant in the ordinary course of business if it has been vetoed byother limited partners. It is important to note that this assessment of noncontrollingrights should be made at the time a majority of kick-out rights through voting interestsis obtained and should be reassessed if there is a significant change to the terms or inthe exercisability of the rights of the noncontrolling limited partner.

Additionally, all noncontrolling rights may be described as protective of the non-controlling limited partner’s investment in the investee. Some noncontrolling rightsallow the noncontrolling limited partner to participate in determining certain significantfinancial and operating decisions of the investee that are made in the ordinary course ofbusiness (referred to as participating rights).

COMMENT: Participation means the ability to block actions proposed by theinvestor that has a majority voting interest or the general partner. Thus, theinvestor with the majority voting interest or the general partner must have theagreement of the noncontrolling shareholder or limited partner to take certainactions. Participation does not mean the ability of the limited partner to initiateactions.

Substantive noncontrolling rights that allow the noncontrolling limited partner toeffectively participate in certain significant financial and operating decisions of theinvestee that are made in the investee’s ordinary course of business (although alsoprotective of the noncontrolling shareholder’s or limited partner’s investment) shouldovercome the presumption that the investor with a majority voting interest or limitedpartner with a majority of kick-out rights through voting interests shall consolidate itsinvestee.

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COMMENT: It must be at least reasonably possible that those events ortransactions that would necessitate such decisions will occur. The ordinary courseof business definition would not include self-dealing transactions with controllinglimited partners.

An entity that is not controlled by a limited partner who holds the majority of kick-out rights because of noncontrolling limited partner veto rights (through participatingrights) is not a VIE if the partners as a group (the holders of the equity investment atrisk) have the power to control the entity and the equity investment meets the otherrequirements. The following guidance addresses considerations of noncontrolling lim-ited partner rights, specifically protective rights, participating rights, and factors toconsider in evaluating whether noncontrolling rights are substantive participatingrights.

Protective RightsNoncontrolling rights (whether granted by contract or by law) that would allow thenoncontrolling limited partner to block partnership actions would be considered protec-tive rights and would not overcome the presumption of consolidation by the limitedpartner with a majority of kick-out rights through voting interests in its investee. Thefollowing list is illustrative of the protective rights that often are provided to thenoncontrolling shareholder or limited partner, but is not all-inclusive:

• Amendments to articles of incorporation or partnership agreements of theinvestee

• Pricing on transactions between the owner of a majority voting interest orlimited partner with a majority of kick-out rights through voting interests andthe investee and related self-dealing transactions

• Liquidation of the investee in the context of ASC 852 on reorganizations or adecision to cause the investee to enter bankruptcy or other receivership

• Acquisitions and dispositions of assets that are not expected to be undertaken inthe ordinary course of business (noncontrolling rights) relating to acquisitionsand dispositions of assets that are expected to be made in the ordinary course ofbusiness are participating rights; determining whether such rights are substan-tive requires judgment in light of the relevant facts and circumstances

• Issuance or repurchase of equity interests

Participating RightsParticipating rights held by a noncontrolling limited partner may overcome the limitedpartner with the majority of kick-out rights ability to consolidate the limited partnership,depending on whether such rights are substantive or not. Substantive participatingrights are those that overcome the presumption that the limited partner with themajority of kick-out rights shall consolidate the limited partnership, whereas non-substantive participating rights do not overcome the presumption that the limitedpartner with the majority of kick-out rights shall consolidate the limited partnership.The following list is illustrative of substantive participating rights, but is not necessarilyall-inclusive:

• Selecting, terminating, and setting the compensation of management responsi-ble for implementing the investee’s policies and procedures

• Establishing operating and capital decisions of the investee, including budgets,in the ordinary course of business

COMMENT: The rights noted above are participating rights because, inthe aggregate, the rights allow the noncontrolling limited partner to effectively

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participate in certain significant financial and operating decisions that occuras part of the ordinary course of the investee’s business and are significantfactors in directing and carrying out the activities of the business. Individ-ual rights, such as the right to veto the termination of managementresponsible for implementing the investee’s policies and procedures,should be assessed based on the facts and circumstances to determine ifthey are substantive participating rights in and of themselves. The likeli-hood that the veto right will be exercised by the noncontrolling limitedpartner should not be considered when assessing whether a noncontrollingright is a substantive participating right.

Factors to Consider in Evaluating Whether There Are SubstantiveParticipating RightsCertain factors shall be considered in evaluating whether noncontrolling rights thatappear to be participating are substantive participating rights, and therefore, whetherthese factors provide for effective participation in certain significant financial andoperating decisions that are made in the investee’s ordinary course of business.

Consideration should be given to situations in which a limited partner with amajority of kick-out rights through voting interests owns such a significant portion ofthe investee that the noncontrolling limited partner has a small economic interest.

COMMENT: As the disparity between the limited partner with a majority ofkick-out rights through voting interests and noncontrolling limited partners in-creases, the rights of the noncontrolling limited partner are presumptively morelikely to be protective rights and shall raise the level of skepticism about thesubstance of the right.

Similarly, although a majority owner is presumed to control an investee, the level ofskepticism about such ability shall increase as the limited partner’s economic interest inthe investee decreases.

The governing documents shall be considered to determine at what level decisionsare made, whether at the limited partner level or at the board level, and the rights ateach level also should be considered. In all situations, any matters that can be put to avote of the limited partners should be considered to determine if other investors,individually or in the aggregate, have substantive participating rights by virtue of theirability to vote on matters submitted to a limited partner vote.

Relationships between the majority and noncontrolling partners (other than aninvestment in the common investee) that are of a related-party nature, as defined in ASC850, should be considered in determining whether the participating rights of thenoncontrolling limited partner are substantive. One example is if the noncontrollinglimited partner in an investee is a member of the immediate family of the majorityshareholder, general partner, or limited partner with a majority of kick-out rightsthrough voting interests of the investee, then the rights of the noncontrolling limitedpartner likely would not overcome the presumption of consolidation by the limitedpartner with a majority of kick-out rights through voting interests in its investee.

Additionally, certain noncontrolling rights may deal with operating or capitaldecisions that are not significant to the ordinary course of business of the investee.Noncontrolling rights related to decisions that are not considered significant for di-recting and carrying out the activities of the investee’s business are not substantiveparticipating rights and would not overcome the presumption of consolidation by thelimited partner with a majority of kick-out rights through voting interests in its investee.Examples of such noncontrolling rights include all of the following:

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• Location of the investee’s headquarters• Name of the investee• Selection of auditors• Selection of accounting principles for purposes of separate

reporting of the investee’s operations

Certain noncontrolling rights may provide for the noncontrolling limited partner toparticipate in certain significant financial and operating decisions that are made in theinvestee’s ordinary course of business; however, the existence of such noncontrollingrights should not overcome the presumption that the majority owner should consoli-date, if it is remote that the event or transaction that requires noncontrolling limitedpartner approval will occur. Remote is defined in ASC 450, Contingencies, as the chanceof the future event or events occurring being slight.

A limited partner with a majority of kick-out rights who has a contractual right tobuy out the interest of the noncontrolling limited partner in the investee for fair value orless should consider the feasibility of exercising that contractual right when determin-ing if the participating rights of the noncontrolling limited partner are substantive. Ifsuch a buyout is prudent, feasible, and substantially within the control of the majorityowner, the contractual right to buy out the noncontrolling limited partner demonstratesthat the participating right of the noncontrolling limited partner is not a substantiveright.

COMMENT: The existence of such call options negates the participatingrights of the noncontrolling limited partner to veto an action of the majority generalpartner, rather than create an additional ownership interest for that majorityshareholder. It would not be prudent, feasible, and substantially within the controlof the majority owner to buy out the noncontrolling limited partner if, for example,the noncontrolling limited partner controls technology that is critical to the inves-tee or the noncontrolling limited partner is the principal source of funding for theinvestee.

STUDY QUESTIONS

7. Which kind of rights may overcome the presumption that a limited partner with themajority of kick-out rights shall consolidate the limited partnership?

a. Non-substantive participating rightsb. Non-substantive protective rightsc. Substantive participating rightsd. Substantive protective rights

8. Which of the following is a barrier that may make kick-out rights less substantive?a. The limited partners have the ability to obtain the information necessary to

exercise the rights.b. There exists an adequate number of qualified replacement general partners.c. The kick-out rights are subject to conditions that make it unlikely they will be

exercisable.d. There exists an explicit, reasonable mechanism by which the LIMITED PART-

NERs holding the rights can conduct a vote to exercise the rights.

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9. Which of the following rights is considered a protective right?

a. Acquisitions of assets undertaken in the ordinary course of business

b. Dispositions of assets undertaken in the ordinary course of business

c. Amendments to articles of incorporation

d. Selecting and setting compensation of management

Examples of Assessing Individual Noncontrolling Rights-Participatingor Protective RightsAn assessment is relevant for determining whether noncontrolling rights overcome thepresumption of control by the limited partner with a majority of kick-out rights.Although the following examples illustrate the assessment of participating rights orprotective rights, the evaluation should consider all factors to determine whether thenoncontrolling rights, individually or in the aggregate, provide for the holders of thoserights to effectively participate in certain significant financial and operating decisionsthat are made in the ordinary course of business.

The rights of the noncontrolling limited partner relating to the approval of acquisi-tions and dispositions of assets that are expected to be undertaken in the ordinarycourse of business may be substantive participating rights. Rights related only toacquisitions that are not expected to be undertaken in the ordinary course of theinvestee’s existing business usually are protective and would not overcome the pre-sumption of consolidation by the investor with a limited partner with a majority of kick-out rights through voting interests in its investee. Additionally, whether a right toapprove the acquisition or disposition of assets is in the ordinary course of businessshould be based on an evaluation of the relevant facts and circumstances. If approval bythe limited partner is necessary to incur additional indebtedness to finance an acquisi-tion that is not in the investee’s ordinary course of business, then the approval by thenoncontrolling limited partner would be considered a protective right.

Existing facts and circumstances should also be considered in assessing whetherthe rights of the noncontrolling limited partner relating to an investee’s incurringadditional indebtedness are protective or participating rights. If it is reasonably possibleor probable that the investee will need to incur the level of borrowings that requiresnoncontrolling limited partner approval in its ordinary course of business, the rights ofthe noncontrolling limited partner would be viewed as substantive participating rights.

The rights of the noncontrolling limited partner relating to dividends or otherdistributions may be protective or participating and should be assessed in light of theavailable facts and circumstances. In other words, rights to block customary or ex-pected dividends or other distributions may be substantive participating rights, whilerights to block extraordinary distributions would be protective rights.

The rights of the noncontrolling shareholder or limited partner relating to aninvestee’s specific action (such as leasing property) in an existing business may beprotective or participating and should be assessed in light of the available facts andcircumstances. For example, if the investee had the ability to purchase, rather thanlease, the property without requiring the approval of the noncontrolling shareholder orlimited partner, then the rights of the noncontrolling shareholder or limited partner toblock the investee from entering into a lease would not be substantive.

The rights of the noncontrolling limited partner relating to an investee’s negotiationof collective bargaining agreements with unions may be protective or participating andshould be assessed in light of the available facts and circumstances. For example, if aninvestee does not have a collective bargaining agreement with a union or if the uniondoes not represent a substantial portion of the investee’s work force, then the rights of

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the noncontrolling limited partner to approve or veto a new or broader collectivebargaining agreement are not substantive.

Provisions that govern what will occur if the noncontrolling limited partner blocksthe action of an owner of a majority voting interest or general partner need to beconsidered to determine whether the right of the noncontrolling limited partner toblock the action has substance. For example, if the partnership agreement provides thatif the noncontrolling limited partner blocks the approval of an operating budget, thenthe budget simply defaults to last year’s budget adjusted for inflation, and if the investeeis a mature business for which year-to-year operating budgets would not be expected tovary significantly, then the rights of the noncontrolling limited partner to block theapproval of the operating budget do not allow the noncontrolling limited partner toeffectively participate and are not substantive.

Noncontrolling rights relating to the initiation or resolution of a lawsuit may beconsidered protective or participating depending on the available facts and circum-stances. If lawsuits are a part of the entity’s ordinary course of business, as is the casefor some patent-holding companies and other entities, then the noncontrolling rightsmay be considered substantive participating rights.

EXAMPLE 1: Two Limited Partners and General PartnerFacts:

Company L is a limited partnership. There are two limited partners, with interests of 60percent and 40 percent, respectively, and one general partner. The GP holds no interestin the limited partnership and under the partnership agreement, the limited partnershave kick-out rights in terms of the right to terminate the general partner with a vote ofmore than 50 percent of the limited partner interests. The 40 percent limited partnerdoes not have any substantive participating rights that can block the 60 percent limitedpartner from exercising its kick-out rights.

Conclusion:

Because the limited partnership offers its limited partners kick-out rights, L should beevaluated for consolidation using the voting interest entity model. Under this model, thelimited partner that has, through voting interests, more than 50 percent of the kick-outrights should consolidate the limited partnership. In this case, the 60 percent limitedpartner holds more than 50 percent of the kick-out rights through its voting interests.There are no substantive participating rights held by the 40 percent partner that couldblock the 60 percent LP’s kick-out rights. Therefore, the 60 percent LP should consoli-date the limited partnership.

EXAMPLE 2: Limited Partner and General PartnerFacts:

Company L is a limited partnership and the 100 percent interest in the limited partner-ship is held as follows: 80 percent held by one limited partner who is not related to theGP and 20 percent held by GP. The general partner owns 20 percent of the equity of thelimited partnership and the limited partner has kick-out rights through voting interests,and a vote of a simple majority of the kick-out rights through voting interests to removethe general partner is required. There are no substantive participating rights

Conclusion:

Because the limited partner has kick-out rights, the limited partnership is evaluated forconsolidation under the voting interest entity model. In evaluating whether the limitedpartner has kick-out rights, the rights held by the GP are ignored. Because the singlelimited partner (exclusive of the limited interests held by the GP) holds more than 50percent of the kick-out rights, and there are no substantive participating rights thatblock the kick-out rights, the 80 percent single limited partner should consolidate the

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LP. The GP does not consolidate the limited partnership. Under the voting interestentity model, in general, a GP does not consolidate a limited partnership.

EXAMPLE 3: Four Equal Limited PartnersFacts:

Company L is a limited partnership. There are four independent limited partners thateach own 10 percent of the equity of the limited partnership in the form of limitedpartnership voting interests. The general partner owns 60 percent of the equity of thelimited partnership and does not have kick-out rights through voting interests. Thelimited partners have kick-out rights through voting interests, and a vote of a simplemajority of the kick-out rights through voting interests to remove the general partner isrequired.

Conclusion:

Because the partnership gives its limited partners kick-out rights, L is evaluated forconsolidation using the voting interest entity model. Accordingly, no partner would bedeemed to have a controlling financial interest in the limited partnership because nosingle limited partner owns a majority of the limited partnership’s kick-out rightsthrough voting interests. Therefore, no partner consolidates the limited partnership.

EXAMPLE 4: No Kick-out RightsFacts:

Company L is a limited partnership with four independent limited partners (none ofwhich have any relationship to the general partner) that each owns 20 percent of theequity of the limited partnership in the form of limited partnership voting interests. Thegeneral partner owns 20 percent of the equity of the limited partnership and the limitedpartners have no kick-out rights and have no participating rights through votinginterests

Conclusion:

First, the limited partnership should be evaluated for consolidation using the VIE modelbecause the limited partnership is a VIE. In this example, the limited partners lack kick-out and participating rights. Therefore, the equity holders (limited partners, in thiscase) lack the power to direct L’s activities. Thus, the limited partnership is a VIE andshould be evaluated for consolidation using the VIE model, not the voting interest entitymodel.

Next, because the VIE model is used, an evaluation must be performed to deter-mine who is the primary beneficiary that should consolidate the limited partnership.Under the VIE model, the party that consolidates the limited partnership is called theprimary beneficiary, which is the party that has a controlling financial interest in thelimited partnership through both power and benefits. Based on the facts given, it wouldappear that the GP is the primary beneficiary that should consolidate the limitedpartnership. The GP has the power to direct the limited partnership’s activities. Also,through its 20 percent interest in the limited partnership, the GP has the obligation toabsorb losses or the right to receive benefits of the limited partnership.

COMMENT: Under the revised voting interest entity model in ASU 2015-02, ageneral partner will not consolidate a limited partnership because only the limitedpartner with the majority of kick-out rights would consolidate the partnership.However, if the limited partnership is a VIE, the VIE model is used. Under the VIEmodel, the party that consolidates the limited partnership is the one with both thepower and benefits.

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¶511 CHANGE 2: FEES PAID TO DECISION MAKERSOR SERVICE PROVIDER AS A VARIABLE INTEREST

EXISTING GAAPExamples of fees paid to decision makers or service providers include those fees paid toasset managers, real-estate property managers, oil and gas operators, and outsourcedR&D providers. Under existing GAAP’s VIE model for consolidation, contracts relatedto fees paid to a decision maker or service provider, such as management or servicefees, are generally not variable interests if all six conditions below are met:

• The fees are compensation for services provided and are commensurate withthe level of effort required to provide those services (e.g., the fees are at anarms-length rate).

• Substantially all of the fees are at or above the same level of seniority as otheroperating liabilities of the entity that arise in the normal course of the entity’sactivities, such as trade payables.

• The decision maker or service provider does not hold other interests in the VIEthat individually, or in the aggregate, would absorb more than an insignificantamount of the entity’s expected losses or receive more than an insignificantamount of the entity’s expected residual returns.

• The service arrangement includes only terms, conditions, or amounts that arecustomarily present in arrangements for similar services negotiated at arm’slength.

• The total amount of anticipated fees are insignificant relative to the total amountof the VIE’s anticipated economic performance.

• The anticipated fees are expected to absorb an insignificant amount of thevariability associated with the entity’s anticipated economic performance.

Fees paid to decision makers or service providers that meet all of the aboveconditions are not considered variable interests. Therefore, if the decision maker orservice provider has no variable interest in the VIE, the decision maker or serviceprovider will not consolidate the VIE. If not all of the six conditions are met, the fees area variable interest and the fee provider (reporting enterprise) must determine if it is aprimary beneficiary that consolidates a VIE.

NEW RULES PER ASU 2015-02ASU 2015-02 changes existing GAAP by eliminating three of the six conditions abovefor evaluating whether a fee paid to a decision maker or a service provider represents avariable interest. As a result, fees paid to a legal entity’s decision maker(s) or serviceprovider(s) are not variable interests if all of the following three conditions are met:

• The fees are compensation for services provided and are commensurate withthe level of effort required to provide those services.

• The decision maker or service provider does not hold other interests in the VIEthat individually, or in the aggregate, would absorb more than an insignificantamount of the VIE’s expected losses or receive more than an insignificantamount of the VIE’s expected residual returns.

• The service arrangement includes only terms, conditions, or amounts that arecustomarily present in arrangements for similar services negotiated at arm’slength.

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Simply put, facts and circumstances should be considered when assessing thethree conditions above. An arrangement that is designed in a manner such that the feeis inconsistent with the decision maker’s or service provider’s role or the type of servicewould not meet those conditions. In order to assess whether a fee meets the threeconditions, a reporting entity may need to analyze similar arrangements among partiesoutside the relationship being evaluated. Furthermore, a fee would not presumptivelyfail the three conditions if similar service arrangements did not exist in the followingcircumstances if the fee arrangement relates to a unique or new service or the feearrangement reflects a change in what is considered customary for the services. Themagnitude of a fee, in isolation, would not cause an arrangement to fail the conditions.

If the decision maker or service provider (reporting entity) concludes that feesreceived represent a variable interest in a VIE (because all three of the conditions arenot met), the reporting entity must evaluate whether it is the primary beneficiary thatshould consolidate the VIE. As previously stated, the decision maker or service providerwould evaluate whether it is the primary beneficiary by evaluating whether it has bothpower and benefits.

Certain fees or payments in connection with agreements that expose a reportingentity (the decision maker or the service provider) to risk of loss in the VIE are variableinterests in the VIE because it would not satisfy the three conditions above. Thus, intesting to determine if the decision maker or service provider is the primary beneficiary,the decision maker or service provider could satisfy the economic criterion by absorb-ing some of the VIE’s losses. Such fees that may absorb some of the VIE’s lossesinclude, but are not limited to, the following:

• Those related to guarantees of the value of the assets or liabilities of a VIE

• Obligations to fund operating losses

• Payments associated with written put options on the assets of the VIE

• Similar obligations, such as some liquidity commitments or agreements (explicitor implicit) that protect holders of other interests from suffering losses in theVIE

For purposes of evaluating the three conditions above, any interest in an entity thatis held by a related party of the decision maker or service provider should be consid-ered in the analysis. As a result, a decision maker or service provider should include itsdirect economic interests in the entity and its indirect economic interests in the entityheld through related parties, considered on a proportionate basis. Indirect interestsheld through related parties that are under common control with the decision makershould be considered the equivalent of direct interests in their entirety.

The term related parties includes those parties identified in ASC 850, Related PartyDisclosures, and certain de facto agents or principals of the variable interest holder. Allof the following are considered to be de facto agents of a reporting entity:

• A party that cannot finance its operations without subordinated financial supportfrom the reporting entity, for example, another VIE of which the reporting entityis the primary beneficiary

• A party that received its interests as a contribution or a loan from the reportingentity

• An officer, employee, or member of the governing board of the reporting entity

• A party that has an agreement that it cannot sell, transfer, or encumber itsinterests in the VIE without the prior approval of the reporting entity. The rightof prior approval creates a de facto agency relationship only if that right couldconstrain the other party’s ability to manage the economic risks or realize the

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economic rewards from its interests in a VIE through the sale, transfer, orencumbrance of those interests. However, a de facto agency relationship doesnot exist if both the reporting entity and the party have right of prior approvaland the rights are based on mutually agreed terms by willing, independentparties.

• A party that has a close business relationship like the relationship between aprofessional service provider and one of its significant clients

EXAMPLE 1: ASU 2015-02, Case J: Investment Fund 1—Annual andPerformance-Based Fees and Additional Interests, as modified by theauthor]Facts:

A fund manager (general partner) creates and sells partnership interests in an invest-ment fund (limited partnership) to external investors (limited partners). The generalpartner is not liable for any losses beyond the interest that the general partner owns inthe fund, and the general partner has a 15 percent ownership interest in the LP. Thegeneral partner’s 15 percent ownership interest in the fund is expected to absorb morethan an insignificant amount of the fund’s expected losses and receive more than aninsignificant amount of the fund’s expected residual returns. The individual limitedpartners do not hold any substantive rights (no kick-out or participating rights) thatwould affect the decision-making authority of the general partner, but they can redeemtheir interests within particular limits set forth by the fund. In addition, the limitedpartners do not have either of the following abilities:

• The ability to remove the general partner from its decision-making authority orto dissolve (liquidate) the fund without cause (as distinguished from with cause)

• The ability to block or participate in certain significant financial and operatingdecisions of the limited partnership that are made in the ordinary course ofbusiness

The limited partners also do not have the ability to direct the activities that mostsignificantly impact the economic performance of the fund. Therefore, the limitedpartnership is a VIE because the limited partners do not have kick-out or participatingrights. Thus, the limited partners lack the power, through voting rights or similarrights, to direct the activities of a legal entity that most significantly impact the entity’seconomic performance.

The general partner is paid an annual fixed fee for the assets under management,and a performance-based fee based on the fund’s profits if it achieves a specified annualprofit level. The annual and performance-based fees paid to the general partner are bothcompensation for services provided and commensurate with the level of effort requiredto provide those services and part of a compensation arrangement that includes onlyterms, conditions, or amounts that are customarily present in arrangements for similarservices negotiated at arm’s length.

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Conclusion:

Based on an evaluation of the three conditions above, the fees paid to the generalpartner meet two of the three conditions as follows:

• The fees are compensation for services provided and are commensurate withthe level of effort required to provide those services. -YES- GIVEN

• The decision maker or service provider does not hold other interests in the VIEthat individually, or in the aggregate, would absorb more than an insignificantamount of the VIE’s expected losses or receive more than an insignificantamount of the VIE’s expected residual returns. NO- GP HOLDS 15 percentOF LP INTEREST

• The service arrangement includes only terms, conditions, or amounts that arecustomarily present in arrangements for similar services negotiated at arm’slength. YES- GIVEN

The general partner and the limited partners are the variable interest holders in theVIE. The fees paid to the general partner (in its role as fund manager) represent avariable interest because the fees paid to the GP fails one of the three conditions(second one above), because of the general partner holding ownership interests that areexpected to absorb more than an insignificant amount of the fund’s expected losses andreceive more than an insignificant amount of the fund’s expected residual returns.

If the general partner was only receiving fees and did not hold ownership interests,and if its related parties did not hold any variable interests in the VIE, then the feeswould not be a variable interest. Next, the GP has to test to determine whether it is theprimary beneficiary that consolidates the LP. Under the VIE model, the decision maker(GP in this case) would evaluate whether it is the entity that has both power andbenefits.

As to the power criterion, the GP must identify which activities of the LP mostsignificantly impact the VIE’s (LP’s) economic performance and determine whether the

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GP has the power to direct those activities. In this case, the activities that mostsignificantly impact the VIE’s economic performance are the activities that significantlyimpact the performance of the managed securities portfolio. In our example, the generalpartner manages the operations of the VIE. Specifically, the general partner establishesthe terms of the VIE, approves the assets to be purchased and sold by the VIE, andadministers the VIE by monitoring the assets and ensuring compliance with the VIE’sinvestment policies. Furthermore, the limited partners of the VIE have no voting rightsand no other rights that provide them with the power to direct the activities that mostsignificantly impact the VIE’s economic performance. As a result, it is apparent that theGP satisfies the power criterion.

Next, the GP must determine whether it satisfies the economic criterion by havingthe obligation to absorb losses of the VIE that could potentially be significant to the VIEor the right to receive benefits from the VIE that could potentially be significant to theVIE. As previously noted, the annual and performance based fees paid to the generalpartner are both compensation for services provided and commensurate with the levelof effort required to provide those services and part of a compensation arrangement thatincludes only terms, conditions, or amounts that are customarily present in arrange-ments for similar services negotiated at arm’s length. As a result, the general partner,through its investment in the fund, has the obligation to absorb losses of the VIE thatcould potentially be significant to the VIE and the right to receive benefits from the VIEthat could potentially be significant to the VIE. On the basis of the specific facts andcircumstances presented, the GP would be the primary beneficiary.

EXAMPLE 2:Same facts as Example 1, except for the fact that the GP has no ownership in the LP.

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Conclusion:

The GP would not consolidate the LP and in fact, no entity would consolidate the LP.Recall that fees paid to a legal entity’s decision maker(s) or service provider(s) are notvariable interests if all of the following three conditions are met:

• The fees are compensation for services provided and are commensurate withthe level of effort required to provide those services. YES-GIVEN

• The decision maker or service provider does not hold other interests in the VIEthat individually, or in the aggregate, would absorb more than an insignificantamount of the VIE’s expected losses or receive more than an insignificantamount of the VIE’s expected residual returns. YES- GIVEN

• The service arrangement includes only terms, conditions, or amounts that arecustomarily present in arrangements for similar services negotiated at arm’slength. YES- GIVEN

In this second example, the GP does not hold any interests in the limited partner-ship. Therefore, it satisfies all three of the conditions noted above. The result is that theGP does not hold any variable interests in the LP (VIE). Because the GP holds novariable interests in the LP, the GP cannot consolidate the LP.

Recall that under the voting interest entity model, a limited partner consolidates anLP only if there is a single limited partner that holds the majority of kick-out rights(more than 50 percent) and there are no substantive participating rights held by non-controlling limited partners that block the single limited partner from exercising itskick-out rights. In this example, there is no single limited partner that has kick-outrights because it has been stated in the example that no limited partners hold kick-outor participating rights. Thus, there is no consolidation using the voting interest entitymodel.

As to the VIE model, there is no limited partner who satisfies the power criterion oreconomic criterion. In fact, it has been clearly stated in the example that the limitedpartners have no control or power over the management of the LP. The conclusion inthis case is that no entity consolidates the LP.

COMMENT: In reviewing Examples 1 and 2, it should be clearer to thereader that the new rules found in ASU 2015-02 make it unlikely that a GP willconsolidate an LP in situations in which the GP holds no LP interests. As long asthe GP compensation (fixed and variable) is commensurate with the servicesprovided, the GP holds no variable interests in the LP and will not have to test todetermine whether the GP is the primary beneficiary that consolidates the LP.

EXAMPLE 3:

Same facts as Example 1, except that the GP has no ownership in the LP, the limitedpartners have substantive kick-out rights under which they can terminate the GPwithout cause, and one limited partner (#1) holds 60 percent of the limited partnershipinterest and 60 percent of the kick-out rights. Additionally, the other 40 percent is heldby numerous limited partners that have no substantive participating rights that canblock the 60 percent limited partner.

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Conclusion:

Because one limited partner holds, through its ownership interest, more than 50percent of the kick-out rights, that one limited partner consolidates the LP using thevoting interest entity model. Under that model, a limited partner consolidates the LPprovided that the limited partner a) holds more than 50 percent of the kick-out rights ofthe LP and, b) the other noncontrolling limited partners (40 percent) do not hold anysubstantive participating rights that could block the controlling limited partner’s rightsunder the kick-out rights.

With respect to the consideration of related parties, under the ASU, in evaluatingthe three conditions to determine whether fees paid to a decision maker or serviceprovider are a variable interest, any interest in the LP held by a related party of thedecision maker or service provider should be considered in the analysis. The termrelated parties includes traditional related parties, as identified in ASC 850, Related PartyDisclosures, and certain de facto agents or principals of the variable interest holder. Asa result, if a related party holds an interest in the VIE (LP), that interest is deemed to beheld by the GP.

EXAMPLE 4:

Same facts as Example 1, except that the GP has no ownership and the GP’s owner,Ralph, has a 25 percent interest in the limited partnership.

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Conclusion:

The GP would consolidate the limited partnership. In this example, the GP does hold aninterest in the limited partnership. The 25 percent limited partnership interest held byGP’s owner, Ralph, is assigned to the GP under the related-party rules. Because onlytwo of the three conditions are satisfied, the fees paid to the decision maker (GP), areconsidered a variable interest. Furthermore, the LP is a VIE because there are no kick-out rights or participating rights held by the limited partners.

Now that GP has a variable interest and the LP is a VIE, GP now must test the LPto determine whether GP is the primary beneficiary that consolidates LP. In thisexample, the GP does satisfy the power criterion because it is the only one that has thepower to direct the LP’s activities. The limited partners do not hold any kick-out rightsor participating rights that could result in the limited partners participating in theoperations of the LP. With respect to the economic criterion, because the GP has a 25percent ownership in the LP (through Ralph’s interest), GP does have the obligation toabsorb losses of the LP or the right to receive benefits from the LP. The result is thatGP satisfies both the power criterion and economic criterion and is considered theprimary beneficiary that consolidates the LP under the VIE consolidation model.

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STUDY QUESTIONS

10. Each of the following identifies an area of change with respect to the amendmentsof ASU 2015-02, except:

a. Evaluating fees paid to a decision maker or a service provider as a variableinterest

b. The effect of fee arrangements on the primary beneficiary determinationc. Primary beneficiary determinationd. The effect of related parties on the primary beneficiary determination

11. Which of the following rights represents the ability to block actions through whichan entity exercises the power to direct the activities of a VIE that most significantlyimpact the VIE’s economic performance?

a. Participating rightsb. Kick-out rightsc. Protective rightsd. Withdrawal rights

¶512 CHANGE 3: THE EFFECT OF FEEARRANGEMENTS ON THE PRIMARY BENEFICIARYDETERMINATIONEXISTING GAAPUnder current GAAP a decision maker or service provider (reporting entity) is deter-mined to be the primary beneficiary of a VIE that consolidates the VIE if it has acontrolling financial interest, by having both power and benefits. Under current GAAP,if a fee paid to a decision maker (such as an asset management fee), is determined to bea variable interest in a VIE, the decision maker must include the fee in its primarybeneficiary determination and could consolidate the VIE by satisfying both the powercriterion and economic criterion through the fees paid to the decision maker.

NEW RULES PER ASU 2015-02The amendments in the ASU specify that some fees paid to a decision maker areexcluded from the evaluation of whether the decision maker is the primary beneficiaryof a VIE. As a result, the amendments make it less likely for a decision maker to meetthe economics criterion solely on the basis of a fee arrangement. In performing theprimary beneficiary test, fees paid to a reporting entity (decision maker or serviceprovider) other than those included in arrangements that expose a reporting entity torisk of loss that meet both of the following conditions should be excluded:

• The fees are compensation for services provided and are commensurate withthe level of effort required to provide those services

• The service arrangement includes only terms, conditions, or amounts that arecustomarily present in arrangements for similar services negotiated at arm’slength

An arrangement that is designed in a manner such that the fee is inconsistent withthe reporting entity’s role or the type of service would not meet those conditions above.To assess whether a fee meets these conditions, a reporting entity may need to analyzesimilar arrangements among parties outside the relationship being evaluated. However,a fee would not presumptively fail those conditions if similar service arrangementsrelate to a unique or new service, or the fee arrangement reflects a change in what is

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considered customary for the services. In addition, the magnitude of a fee, in isolation,would not cause an arrangement to fail those conditions.

Furthermore, fees or payments in connection with agreements that expose areporting entity (the decision maker or service provider) to risk of loss in the VIEshould not be eligible for this evaluation. These types of fees include, but are not limitedto, the following:

• Those related to guarantees of the value of the assets or liabilities of a VIE

• Obligations to fund operating losses

• Payments associated with written put options on the assets of the VIE

• Similar obligations such as some liquidity commitments or agreements (explicitor implicit) that protect holders of other interests from suffering losses in theVIE

¶513 CHANGE 4: THE EFFECT OF RELATED PARTIESON THE PRIMARY BENEFICIARY DETERMINATIONEXISTING GAAPUnder the VIE consolidation model, in instances in which no single party has acontrolling financial interest in a VIE, current GAAP requires interests held by areporting entity’s related parties to be treated as though they belong to the reportingentity when evaluating whether a related party group has the characteristics of aprimary beneficiary, to consolidate the VIE.

NEW RULES PER ASU 2015-02The fourth primary change made by ASU 2015-02 to the consolidation rules involvesconsidering the effect of related parties on the determination of the primary beneficiaryunder the variable interest rules. The amendments in ASU 2015-02 reduce the applica-tion of the related party guidance for VIEs on the basis of the following three changes:

• For single decision makers, related-party relationships must be consideredindirectly on a proportionate basis, rather than in their entirety.

• After the assessment above is performed, related-party relationships should beconsidered in their entirety for entities that are under common control only ifthat common control group has the characteristics of a primary beneficiary.That is, the common control group collectively has a controlling financialinterest.

• If the second assessment is not applicable, but substantially all of the activities ofthe VIE are conducted on behalf of a single variable interest holder (excludingthe decision maker) in a related party group that has the characteristics of aprimary beneficiary, that single variable interest holder must consolidate theVIE as the primary beneficiary.

The ASU does not amend the related-party guidance for situations in which poweris shared between two or more entities that hold variable interests in a VIE.

¶514 CHANGE 5: CERTAIN INVESTMENT FUNDSEXISTING GAAPASU 2010-10, Consolidation (Topic 810): Amendments for Certain Investment Funds,indefinitely deferred the effective date of the VIE consolidation requirements forinvestment companies.

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NEW RULES PER ASU 2015-02ASU 2015-02 rescinded the indefinite deferral included in ASU 2010-10. Additionally, theASU provides a scope exception from ASC 810 consolidation rules for reporting entitieswith interests in legal entities that are required to comply with or operate in accordancewith requirements similar to those in Rule 2a-7 of the Investment Company Act of 1940for registered money market funds. As a result, a reporting entity should not consoli-date a legal entity that is required to comply with or operate in accordance withrequirements that are similar to those included in Rule 2a-7 of the Investment CompanyAct of 1940 for registered money market funds.

A legal entity that is not required to comply with Rule 2a-7 qualifies for thisexception if it is similar in its purpose and design, including the risks that the legalentity was designed to create and pass through to its investors, as compared with a legalentity required to comply with Rule 2a-7. It is important to note that a reporting entitysubject to this scope exception is required to disclose any explicit arrangements toprovide financial support to legal entities that are required to comply with or operate inaccordance with requirements that are similar to those included in Rule 2a-7, as well asany instances of such support provided for the periods presented in the performancestatement. For purposes of applying this disclosure requirement, the types of supportthat should be considered include, but are not limited to, any of the following:

• Capital contributions (except pari passu investments)

• Standby letters of credit

• Guarantees of principal and interest on debt investments held by the legal entity

• Agreements to purchase financial assets for amounts greater than fair value(e.g., at amortized cost or par value when the financial assets experiencesignificant credit deterioration)

• Waivers of fees, including management fees

The FASB noted in its Basis for Conclusions section of ASU 2015-02 that theconsolidation guidance in ASC 810 will not apply to a reporting entity’s interest in anentity that is required to comply with or operate in accordance with requirements thatare similar to those included in Rule 2a-7 of the Investment Company Act of 1940 forregistered money market funds. Previously, such funds were exempt from application ofthe ASC 810 consolidation rules under the indefinite deferral provision found in FAS167. In ASU 2015-02, the FASB removed the indefinite deferral of FAS 167 and provideda permanent exemption for certain money market funds covered under Rule 2a-7 of theInvestment Company Act of 1940.

The FASB concluded that consolidation does not produce more meaningful finan-cial reporting than nonconsolidated results. Factors that the FASB considered inmaking its exemption include:

• Input from respondents indicated that consolidation of money market fundsnegatively impacts the ability to analyze financial statements to understand afund manager’s compensation and to distinguish between a fund manager’sassets and liabilities and those of the consolidated money market fund.

• Consolidation could be distortive due to the regulated nature of registeredmoney market funds, including the portfolio quality, maturity, and diversificationof the investments held by the money market funds, in its decision to provide ascope exception.

In conjunction with its decision to provide a scope exception, the FASB decidedthat the exemption should not be limited to registered money market funds that arerequired to comply with Rule 2a-7, but that the exemption should also apply to other

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funds that operate in a manner similar to registered money market funds that arerequired to comply with that Rule. This decision is consistent with the conclusion forthe indefinite deferral of Statement 167 for certain money market funds. However, theFASB decided to require fund sponsors of money market funds meeting this scopeexception to disclose explicit arrangements to provide financial support to the moneymarket funds they manage as well as any instances of financial support provided for theperiods presented in the performance statement. Disclosing that information benefitsusers of financial information and presents minimal costs to preparers of financialinformation.

¶515 ASU 2015-02 TRANSITIONSAs previously noted, the ASU is effective for public business entities, for fiscal years,and for interim periods within those fiscal years, beginning after December 15, 2015.For all other entities, the ASU is effective for fiscal years beginning after December 15,2016, and for interim periods within fiscal years beginning after December 15, 2017.

If a reporting entity is required to consolidate a legal entity as a result of the initialapplication of the ASU, the initial measurement of the assets, liabilities, and noncontrol-ling interests of the legal entity depends on whether the determination of their carryingamounts is practicable. To that end, carrying amounts refers to the amounts at which theassets, liabilities, and noncontrolling interests would have been carried in the consoli-dated financial statements if the requirements of the ASU had been effective when thereporting entity first met the conditions to consolidate the legal entity. If determiningthe carrying amounts is practicable, the reporting entity should initially measure theassets, liabilities, and noncontrolling interests of the legal entity at their carryingamounts. However, if determining the carrying amounts is not practicable, the assets,liabilities, and noncontrolling interests of the legal entity should be measured at fairvalue at the date the ASU first applies.

Any difference between the net amount added to the statement of financial positionof the reporting entity and the amount of any previously recognized interest in thenewly consolidated legal entity should be recognized as a cumulative-effect adjustmentto retained earnings. A reporting entity should also describe the transition method(s)applied and disclose the amount and classification in its statement of financial position ofthe consolidated assets or liabilities by the transition method(s) applied. In addition, areporting entity that is required to consolidate a legal entity as a result of the initialapplication of the ASU may elect the fair value option provided by the Fair Value OptionSubsections of Subtopic 825-10 on financial instruments, but only if the reporting entityelects the option for all financial assets and financial liabilities of that legal entity that areeligible for this option under those Fair Value Option Subsections. This election isrequired to be made on a legal entity by legal entity basis. Along with the disclosuresrequired in those Fair Value Option Subsections, the reporting entity is also required todisclose all of the following:

• Management’s reasons for electing the fair value option for a particular legalentity or group of legal entities

• The reasons for different elections if the fair value option is elected for somelegal entities and not others

• Quantitative information by line item in the statement of financial positionindicating the related effect on the cumulative-effect adjustment to retainedearnings of electing the fair value option for a legal entity

Furthermore, if a reporting entity is required to deconsolidate a legal entity as aresult of the initial application of this ASU, the initial measurement of any retainedinterest in the deconsolidated former subsidiary depends on whether the determination

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of its carrying amount is practicable. In this context, carrying amount refers to theamount at which any retained interest would have been carried in the reporting entity’sfinancial statements ASU had been effective when the reporting entity became involvedwith the legal entity or no longer met the conditions to consolidate the legal entity.

Any difference between the net amount removed from the statement of financialposition of the reporting entity and the amount of any retained interest in the newlydeconsolidated legal entity should be recognized as a cumulative-effect adjustment toretained earnings. Additionally, a reporting entity shall disclose the amount of anycumulative-effect adjustment related to deconsolidation separately from any cumulative-effect adjustment related to consolidation of entities.

The determinations of whether a legal entity is a VIE and which reporting entity, ifany, should consolidate the legal entity should be made as of the date the reportingentity became involved with the legal entity or, if events have occurred requiringreconsideration of whether the legal entity is a VIE and which reporting entity, if any,should consolidate the legal entity, as of the most recent date at which the ASU wouldhave required consideration. If, at transition, it is not practicable for a reporting entity toobtain the information necessary to make the determinations as of the date thereporting entity became involved with a legal entity or at the most recent reconsidera-tion date, the reporting entity should make the determinations as of the date on whichthe ASU is first applied.

If the determinations of whether a legal entity is a VIE and whether the VIE shouldbe consolidated, then the consolidating entity should measure the assets, liabilities, andnoncontrolling interests of the legal entity at fair value as of the date on which the ASUis first applied.

With respect to transition method, the ASU may be applied retrospectively inpreviously issued financial statements for one or more years with a cumulative-effectadjustment to retained earnings as of the beginning of the first year restated. Earlyadoption, including adoption in an interim period, is also permitted. If an entity earlyadopts the ASU in an interim period, any adjustments should be reflected as of thebeginning of the fiscal year that includes that interim period. In addition, an entity isrequired to provide certain disclosures in the period the entity adopts the ASU.

STUDY QUESTION

12. Company Z is a decision maker for Company Y and receives management feesfrom Y for its services. Under ASU 2015-02, fees paid to Company Z by Company Y arenot variable interests if certain conditions are met. Which of the following is one of theconditions?

a. a. Substantially all of the fees are at or above the same level of seniority asother operating liabilities of the entity that arise in the normal course of theentity’s activities.

b. b. The total amount of anticipated fees are insignificant relative to the totalamount of the VIE’s anticipated economic performance.

c. c. The fees are compensation for services provided and are commensuratewith the level of effort required to provide those services.

d. d. The anticipated fees are expected to absorb an insignificant amount of thevariability associated with the entity’s anticipated economic performance.

CPE NOTE: When you have completed your study and review of chapters4-5, which comprise Module 2, you may wish to take the Final Exam for thisModule. Go to CCHGroup.com/PrintCPE to take this Final Exam online.

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MODULE 3: OTHER CURRENTDEVELOPMENTS—CHAPTER 6: GAAP forTerrorism and Natural Disasters¶601 WELCOMEThis chapter provides an overview of the accounting and reporting requirements withrespect to costs incurred related to terrorism and natural disasters. This includes adiscussion of the disclosure requirements, the treatment of insurance recoveries, aswell as the related income statement presentation and certain tax consequences.



• Identify the accounting and disclosure requirements related to certain risks anduncertainties and those related to terrorism and natural disasters

• Recognize how certain insurance recoveries should be accounted for in anentity’s financial statements

• Differentiate between GAAP and tax reporting requirements of costs incurredrelated to terrorism and natural disasters

¶603 INTRODUCTIONIn April 2013, Boston was the victim of one of the U.S.’s worst terrorist attacks yet, withthree individuals dead and more than 260 persons wounded. More than 300 businessesin the Boylston Street, Downtown Boston area were shut down for more than a week asinvestigators sorted through the rubble and debris left behind by the two bombs thatexploded. Unfortunately, the effects of any terrorist attack are not limited to theimmediate act that was perpetrated and extend into the lives of many individuals andbusinesses.

Prior to the Boston attack, there have been several large natural disasters such asHurricanes Katrina and Sandy, and ongoing tornados and earthquakes. The purpose ofthis chapter is to address some of the GAAP issues that may have to be considered as aresult of gains and losses related to terrorism and acts of God. Some of these issueswere addressed going as far back as the September 11th attack in New York. Others arenow being brought to the forefront as the United States realizes that terrorism is nolonger an isolated 9/11 attack, but now is an ongoing risk that is part of the fabric of theUnited States. GAAP issues pertaining to terrorism are now becoming relevant. As fornatural disasters, they are ongoing and are likely to recur in the future.

In this section, the following issues related to gains and losses involving terrorismand natural disasters are addressed:

• Disclosure issues-risks and uncertainties (terrorism versus acts of God and theGAAP exception)

• Presentation of gains and losses from terrorism and acts of God

• Dealing with insurance including:

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- Presentation of business interruption insurance

- Dealing with involuntary conversions for GAAP

- Dealing with gain contingencies and insurance recoveries

¶604 DISCLOSURE CONSIDERATIONSASC 275, Risks and Uncertainties, requires that reporting entities make disclosures intheir financial statements about the risks and uncertainties existing as of the date ofthose statements in the following areas:

• Nature of operations

• Use of estimates in the preparation of financial statements

• Certain significant estimates

• Current vulnerability due to certain concentrations

However, ASC 275’s disclosure requirements do not encompass risks and uncertaintiesthat might be associated with any of the following:

• Management or key personnel

• Proposed changes in governmental regulations

• Proposed changes in accounting principles

• Deficiencies in the internal control structure

• The possible effects of acts of God, war, or sudden catastrophes

ASC 275 notes that the vulnerability from concentrations arises because an entity isexposed to risk of loss greater than it would have had if it had mitigated its risk throughdiversification. As a result, financial statements are required to disclose the concentra-tions if, based on information known to management before the financial statements areissued or are available to be issued, all of the following criteria are met:

• The concentration exists at the date of the financial statements.

• The concentration makes the entity vulnerable to the risk of a near-term severeimpact.

• It is at least reasonably possible that the events that could cause the severeimpact will occur in the near term.

In order for there to be a concentration that exposes an entity to a near-term severeimpact, it must be at least reasonably possible that such a severe impact will occur inthe near term (within one year). ASC 275 defines near term, and severe impact as thefollowing:

Near term: A period of time not to exceed one year from the date of the financialstatements

Severe impact: A significant financially disruptive effect on the normal functioningof an entity. Severe impact is a higher threshold than material. Matters that areimportant enough to influence a user’s decisions are deemed to be material, yetthey may not be so significant as to disrupt the normal functioning of the entity

The question is whether the potential risk of a terrorist attack results is a currentvulnerability due to a terrorist attack. The same question applies to an act of God. Theanswer is that GAAP has not addressed terrorist attacks in the capacity of whether suchan attack results in a disclosure of the current vulnerability due to a terrorist attack.GAAP also does not specifically address the disclosures as they relate to acts of God oreven war.

EXAMPLE: Company X is a restaurant in downtown New York City. Becauseof its location, there is a concentration (terrorist attack) that exposes X to a near-

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127MODULE 3 - CHAPTER 6 - GAAP for Terrorism and Natural Disasters

term severe impact. Further, it is reasonably possible that a terrorist attack willoccur in the near term (within the next year) and it would have a severe impact onX’s business. The primary question is, does the concentration of terrorism riskresult in a required disclosure under ASC 275?

On its face, the answer is yes. However, ASC 275 states that disclosure require-ments do not apply to risks and uncertainties involving “the possible effects of acts ofGod, war, or sudden catastrophes.� A terrorist attack is not an act of God, and may ormay not be an act of war, but it would appear to fall into the category of a suddencatastrophe. Although ASC 275 does not define the term catastrophe the dictionarydefinition is “an event causing great and often sudden damage or suffering; a disaster.�

COMMENT: The author believes a terrorist attack would be considered asudden catastrophe. Therefore, the author believes that regardless of where abusiness is located (downtown Manhattan, Boston), there is no disclosure require-ment pertaining to a concentration of risk or uncertainty of a terrorist attack. Thesame conclusion would be reached if Company X is located on the ocean andsubject to the risk of a flood or hurricane. No disclosure would be required underthe “possible effects of acts of God, war, or sudden catastrophes� exception.

¶605 LOSSESS FROM TERRORISM OR ACTS OF GODLosses from terrorist attacks and acts of God can be significant and can include physicaldamage to premises, lost revenue and profits from business shutdown, additionalconsulting fees for psychotherapists and medical care for employees, relocation costs,and employee expenses to carry employees during a shutdown. The 9/11 and Bostonterrorist attacks and the Katrina storm resulted in businesses having significant lossesthat, in some cases, were not covered by insurance. In preparing financial statements,companies with losses from terrorism and/or acts of God have asked the question as towhether such losses (or in limited cases gains) qualified for extraordinary treatment, tobe shown net of tax below the line.

Through a series of Emerging Issues Task Force consensus opinions (EITFs) andpractice aids, the FASB has noted that gains or losses from terrorist attacks and mostacts of God do not qualify for extraordinary treatment because they do not satisfy theunusual nature and infrequency of occurrence criteria. Although the “unusual nature�criterion may be met, the “infrequency of occurrence� criterion is not satisfied becauseit is reasonable to expect another terrorist attack or act of God to recur in theforeseeable future, taking into account the environment in which the entity operates. Inaddition, the magnitude of any loss has no impact on whether the loss qualifies forextraordinary treatment.

In 2015, the FASB issued ASU 2015-01, Income Statement—Extraordinary andUnusual Items (Subtopic 225-20): Simplifying Income Statement Presentation by Elimi-nating the Concept of Extraordinary Items. This ASU eliminates all transactions fromextraordinary treatment effective for years beginning after 2015. As a result, the debateas to whether a gain or loss from a terrorist attack qualifies for extraordinary treatmentbecomes moot beginning in 2016.

¶606 INSURANCE RECOVERIES FROM TERRORISTATTACKSWith respect to insurance recoveries, the primary question relates to how insurancerecoveries of losses and costs incurred as a result of a natural disaster, terrorist act, oract of God be classified in the statement of operations, and when those recoveriesshould be recognized. GAAP prescribes that any insurance recoveries of losses and

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costs incurred should be classified in a manner consistent with the related losses withinthe income from continuing operations. In addition, an asset (i.e. receivable) relating tothe insurance recovery should be recognized only when realization of the claim forrecovery of the loss recognized in the financial statements is deemed probable (UnderASC 410, if a claim is the subject of litigation, a rebuttable presumption exists thatrealization of the claim is not probable). Furthermore, a gain should not be recognizeduntil any contingencies relating to the insurance claim have been resolved.

COMMENT: In accounting for insurance payments to cover losses, entitiesshould follow the guidance in ASCs 210-20, 225-20, 225-30, 410-30, 605-40, and 815.FASB ASC 605-40 clarifies the accounting for involuntary conversions of nonmone-tary assets (such as property or equipment) to monetary assets (such as insuranceproceeds). It requires that a gain or loss be recognized when a nonmonetary assetis involuntarily converted to monetary assets even though an enterprise reinvestsor is obligated to reinvest the monetary assets in replacement nonmonetary assets.

FASB ASC 605-40-45-1 prescribes that gain or loss resulting from an involuntaryconversion of a nonmonetary asset to monetary assets is required to be classified inaccordance with the provisions of Subtopic 225-20 (Extraordinary and Unusual Items).That guidance generally requires that an asset relating to the insurance recovery shouldbe recognized only when realization of the claim for recovery of a loss recognized in thefinancial statements is deemed probable (as that term is used in FASB ASC 450). Inaddition, under FASB ASC 450-30-25-1, a gain (that is, a recovery of a loss not yetrecognized in the financial statements or an amount recovered in excess of a lossrecognized in the financial statements) should not be recognized until any contingen-cies relating to the insurance claim have been resolved. It is important to note that insome circumstances, losses and costs might be recognized in the statement of opera-tions in a different (earlier) period than the related recovery.

An additional consideration relates to FASB ASC 225-30, which prescribes thatentities may choose how to classify such recoveries in the statement of operations,provided that classification does not conflict with existing GAAP requirements. Oneissue to consider is that an entity is not allowed to record a receivable due from theinsurance company for the insurance proceeds from a recovery until realization of theamount of insurance is probable. The reason is because the receivable is considered again contingency until the amount of the insurance to be received is settled with theinsurance company. What that means is that there could be a fire or other calamity thatoccurs in the middle of a year but is not settled with the insurance company by yearend. The entity is not allowed to record a receivable for the estimated insurancereceivable until the company has settled the claim with the insurance company.Recording a “best estimate� as a receivable is not allowed because to do so would resultin the company recording a gain contingency, which is not allowed under GAAP.

EXAMPLE: Company X’s equipment was heavily damaged in April 2013 fromthe Boston terrorist act. The company maintains insurance on the equipment thatprovides for recovery of its replacement value. The equipment has a net book valueof $1,000 and an estimated replacement value of $1,500 as of April 2013. Prior to itsDecember 31, 2013 year end, the company files a claim with its insurer forrecovery of $1,500. Based on discussions with the insurer, the company concludesthat it is probable that the insurer will settle the claim for at least $1,200. However,as of December 31, 2013, the insurer has communicated to the company that theamount of final settlement is subject to verification of the identity of the equipmentdamaged and receipt of additional market data regarding its value.

Conclusion: Because the insurance claim has not been resolved, a gain on theinsurance claim cannot be recognized in the company’s December 31, 2013 year end

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income statement. The company should record a claim receivable limited to the $1,000net book value of the damaged asset because it is probable that there will be a recoveryof the loss. The book value should be credited for $1,000 as the equipment is removed.Any remaining recovery beyond $1,000 should be recognized as a gain only when theinsurance claim (contingency) has been resolved; that is, when the identity of thedamaged equipment and the market data have been finalized to the satisfaction of theinsurance company.

EXAMPLE: Company X owns and operates a retail store in downtown Bostonand maintains insurance to cover business interruption losses. Under the policy,the Company receives compensation for lost profits in the event of a businessinterruption, including a terrorist attack. In April 2013, the company’s store isdamaged from the terrorist attack. As of September 30, 2013, the company has fileda claim with its insurer to recover its estimated lost profit through September 30,2013. The company has not previously filed a claim under its insurance policy andis uncertain of the final settlement amount. As a result, the company believes therecould be a dispute regarding the scope of terrorism coverage under the policy. Theparties have not agreed on a settlement as of the date that the company issues itsfinancial statements for the period ended September 30, 2013.

Conclusion: Company X should not recognize a gain because contingencies related tothe recovery remain unresolved. The company should recognize a gain when thosecontingencies are resolved by settlement of the claim with the insurance company.

STUDY QUESTION

1. How should a loss incurred as a result of a terrorist attack be classified?

a. As an extraordinary item

b. As part of income from discontinued operations

c. As part of income from continuing operations

d. As part of retained earnings

¶607 INVOLUNTARY CONVERSIONS UNDER GAAPFor tax purposes, the Code Sec. 1033 provides a special rule to deal with disasters underthe involuntary conversion rules. Code Sec. 1033 states the following:

• If property is damaged due to a condemnation, theft, seizure, or destruction, anda taxpayer receives insurance proceeds, the gain or loss from the involuntaryconversion is not taxable if reinvested in qualified replacement property within aperiod of time.

• The gain from receipt of insurance proceeds is non-taxable to the extent that theinsurance proceeds are used to purchase qualifying replacement property (e.g.,property that is similar to, or related to in use to, the property that was lost ortaken) within a two-year period that ends two years after the close of the first taxyear in which any part of the gain on the conversion is realized (three years forcertain condemned property).

• In lieu of recording a gain, the insurance proceeds reduce the basis of thereplacement property.

However, the non-recognition of gain rules found in Code Sec. 1033 do not apply toGAAP. Therefore, for GAAP purposes, an involuntary conversion is treated as a sale ofthe converted property and a gain or loss is recognized on the income statement.

¶607


Deferred income taxes must be recorded on the basis difference for GAAP and taxpurposes. For tax purposes, the basis of the replacement property is lower than GAAPbecause of the reduction in the tax basis for the non-recognition of the gain. Further-more, ASC 605-40-25 prescribes the following:

“An involuntary conversion of a nonmonetary asset to monetary assets (e.g.,cash) and the subsequent reinvestment of the monetary assets is not theequivalent to an exchange transaction between an entity and another entity.The conversion of a nonmonetary asset to monetary assets is a monetarytransaction, whether the conversion is voluntary or involuntary, and such aconversion differs from exchange transactions that involve only nonmonetaryassets. To the extent the cost of a nonmonetary asset differs from the amount ofmonetary assets received, the transaction results in a gain or loss that shall berecognized.”

GAAP for involuntary conversions, on the other hand, requires the following:

• The transaction must be recorded as a sale of the asset when the asset(building, etc.) is converted to a monetary asset (i.e., when the entity receivescash or records a receivable from the insurance company).

• A gain or loss on the transaction is recorded when the entity receives cash orrecords a receivable for the insurance amount that is settled with the insurancecompany.

However, it can take an extensive amount of time to settle with the insurance companyand that timeline can extend over one or more reporting periods. In such a situation, anentity is precluded from recording a receivable for the insurance settlement and a gainor loss on the transaction. Further, until the transaction is settled and a gain or loss isrecognized, the entity cannot remove the underlying fixed asset from its records.

EXAMPLE: Company X, a calendar year end filer, has a fire on September 30,20X1 that damages its plant, making it inoperable. The plant’s carrying book valueat the date of the fire was $900,000 (Cost of $15million less accumulated deprecia-tion of $600,000). At December 31, 20X1, the company is still negotiating with theinsurance company and has received an advance in the amount of $100,000 to startrepairing the facility. The company expects to receive approximately $500,000 intotal from the insurance company but has not settled on that amount at December31, 20X1. At December 31, 20X1, the company has spent about $200,000 formiscellaneous improvements to secure the property. No new renovations werestarted until 20X2. In addition, at December 31, 20X1, the company estimates thatthe fair value of the damaged building is $500,000, the amount it expects to receivefrom the insurance company.

Conclusion: Because Company X has not settled with the insurance company, it isprecluded from recording a receivable and a gain and loss as if the property was sold.As a result, the following has to be recorded at December 31, 20X1:

• Insurance proceeds received in advance ($100,000) should be recorded in adeposit account as a liability.

• The $200,000 spent on repairs to date should be recorded as either a repair andmaintenance expense, or as construction in progress (CIP), if it is part of thenew construction.

• The building should be written down to $500,000 (its estimated fair value) withan impairment loss.

¶607


Entries: December 31, 20X1: dr cr

Cash 100,000

Deposit liability- insurance proceeds 100,000

Construction in progress 200,000

Cash 200,000

Impairment loss 400,000

Plant 400,000

[$900,000 -$500,000]

Assume further that in March 20X2, X settles with the insurance company for $525,000and receives a check for $425,000 ($525,000 less $100,000 advance received in 20X1). Again or loss on the transaction should be recorded as follows:

Insurance proceeds $525,000

Basis:

Cost (1) 1,100,000

Accumulated depreciation (600,000)

Book value 500,000

Gain on transaction $25,000

(1) Original cost $1.5 M less impairment loss $(400,000) = $1.1 million.

Entries: March 20X2: dr cr

Cash 425,000


Building 1,100,000

AD- building 600,000

Gain on transaction 25,000

COMMENT: Because of the timing of settling the insurance proceeds, anentity will likely have to record an impairment loss in one period, and then record again on the transaction representing a sale in the following period once theinsurance proceeds are settled. The result is a mismatch of revenue and expense inthat the impairment loss results in a lower basis and thus, a higher gain in thesubsequent period. Because GAAP does not allow an entity to estimate theinsurance proceeds and record the receivable prior to settlement, there is adistortion of revenue and expense among periods. To date, the FASB has notfocused on this issue.

EXAMPLE: Assume that at December 31, 20X1, the fair value of the buildingis estimated to be $2million, which is the insurance proceeds that the companyexpects to receive in 20X2, even though it has not been settled at December 31,20X1. All other facts are the same as the previous example. In this situation, therewould be no write down of the building for impairment. Under ASC 360, Impair-ments, an impairment of a fixed asset (building in this case), exists if the undis-counted future cash flows from its use (and sale) are less than its carrying amount.In this case, the estimated future undiscounted cash flows consist of the insuranceproceeds that are expected to be $2million, which exceeds the carrying amount of$900,000. Thus, there is no impairment and no write-down of the building at theend of 20X1.

¶607


Conclusion: The result is as follows:Entries: December 31, 20X1: dr cr

Cash 100,000


Construction in progress 200,000

Cash 200,000

Impairment loss 0

Plant 0

Assuming that in March 20X2, X settles with the insurance company for $2,000,000 andreceives a check for $1,900,000 ($1,900,000 less $100,000 advance received in 20X1). Again or loss on the transaction should be recorded as follows:

Insurance proceeds $2,000,000

Basis:

Cost (1) 1,500,000

Accumulated depreciation (600,000)

Book value 900,000

Gain on transaction $1,100,000

Entries: March 20X2: dr cr

Cash 1,900,000


Building 1,500,000

AD- building 600,000

Gain on transaction 1,100,000

STUDY QUESTION

2. With respect to insurance recoveries, how should an insurance receivable behandled?

a. It should be booked as a gain contingency.

b. It should be recorded only when realization is probable.

c. It should not be recorded and should be accounted for on a cash basis.

d. It should be recorded once a best estimate of the amount that might berecovered is known.

¶608 BUSINESS INTERRUPTION INSURANCERECOVERIESThe governing authority for business interruption insurance recoveries is found in ASC225-30, Income Statement-Business Interruption Insurance, which deals with businessinterruption insurance, and ASC 605, Revenue Recognition, for insurance proceedsrelated to property damage. In other areas, ASC 410, Asset Retirement and Environmen-tal Obligations and ASC 605 provide that any insurance recoveries are netted against therelated loss on the same income statement line.

¶608


An entity may choose how to classify business interruption insurance recoveries inthe statement of operations, as long as that classification is not contrary to existingGAAP. With respect to property insurance recoveries, ASC 605 provides that anyinsurance recoveries are netted against the related loss on the same income statementline. Specifically, ASC 605 states that a gain or loss should be recognized on thedifference between the carrying amount of the asset and the amount of monetary assetsreceived (insurance recovery received) in the period of the involuntary conversion. As aresult, the insurance recoveries are netted against the related loss (the carrying amountof the insured asset) and shown in the other income section of the income statement.

Business interruption insurance differs from other types of insurance coverage inthat it protects the prospective earnings or profits of the insured entity. It providescoverage if business operations are suspended due to loss of use of property andequipment resulting from a covered cause of loss. Business interruption insurancecoverage usually provides for reimbursement of certain costs and losses incurredduring the reasonable period of time to rebuild, repair, or replace the damagedproperty. Types of costs typically covered include the following:

• Gross margin that was “lost� or not earned due to the suspension of normaloperations

• A portion of fixed charges and expenses in relation to that lost gross margin• Other expenses incurred to reduce the loss from business interruption, such as

rental of a temporary facility and equipment, use of subcontractors, etc.

ASC 605 applies only to recoveries of certain types of losses and costs that have beenrecognized in the income statement. On the other hand, a portion of recoveries frombusiness interruption insurance represents a reimbursement of “lost margin� ratherthan a recovery of losses or other costs incurred. As a result, there are no direct costsrecorded on the income statement to which the insurance recovery relates.

While an entity may choose how to classify business interruption insurance recov-eries in the statement of operations, as long as that classification is not contrary toexisting GAAP, the following information should be disclosed in the notes to financialstatements in the period(s) in which the insurance recoveries are recognized:

• The nature of the event resulting in the business interruption losses.• The aggregate amount of business interruption recoveries recognized during

the period and the line item(s) in the statement of operations in which thoserecoveries are classified.

COMMENT: ASC 225 gives companies latitude in presenting a businessinterruption insurance recovery in the income statement. Because the underly-ing losses may not be recorded, such as lost revenue, there may not be aparticular line item(s) to which the recovery relates. One approach to displaywould be to present the insurance recovery in the lines to which the “lost items�related. Note that although ASC 225 applies to business interruption insurancerecoveries, the same concept applies to other insurance recoveries, includingproperty insurance recoveries.

EXAMPLE: Assume there is a fire in a building. The building is condemnedand the owner recovers $250,000 for lost rents and another $500,000 for propertydamage while the property is being repaired. Other information follows:

¶608


Rent revenue $2,000,000

Operating expenses (900,000)

Insurance recovery ($250,000 + $500,000) 750,000

Net amounts $1,850,000

Assume the lost rents recovery is calculated as follows:Lost rents $400,000

Saved utilities and other direct costs (150,000)

Business interruption insurance recovery-lost $250,000rents

Assume the book value of the building (without land) that is condemned is$200,000 so that there is a gain on that portion of the transaction of $300,000 asfollows:Property insurance proceeds $500,000

Book value of real estate (200,000)

Gain on building condemnation $300,000

The net income to be presented is as follows:Rent revenue $2,000,000


Business interruption insurance recovery 250,000

Gain on building condemnation 300,000

Net income $1,650,000

Conclusion: With respect to the $250,000 business interruption insurance, ASC 225permits a company to present it in any way an entity chooses on its income statement.The following are two suggested presentation formats. Option 1 is to categorize therecovery in those sections of the income statement to which the “lost items� relate. Inthis case, the $250,000 recovery would be split into two sections: $400,000 presented asa credit to rental income, and the other $150,000 presented as an increase to operatingexpenses.

Allocation of business interruption insurance

Initial Allocation of the Income statementamounts recovery presentation

Rent revenue $2,000,000 $400,000 $2,400,000

Operating expenses (900,000) (150,000) (1,050,000)

Business interruption 250,000 (250,000) 0insurance recovery

Net income $1,350,000 $ 0 $1,350,000

The income statement presentation would look like this:X Real Estate CompanyStatement of Income

For the Year Ended December 31, 20X1


Operating expenses (1,050,000)

Other income:

Gain on condemnation of building 300,000


¶608


Option 2 is to present the business interruption insurance recovery as an other incomeitem as follows:

X Real Estate CompanyStatement of Income

For the Year Ended December 31, 20X1



Net operating income 1,100,000

Other income:

Business interruption insurance recovery 250,000

Gain on condemnation of building 300,000


For tax purposes, the $500,000 of property insurance proceeds would be credited to thebuilding asset, resulting in a $300,000 basis difference, which would be a temporarydifference for deferred income tax purposes as follows:

Tax TemporaryGAAP purposes difference

Book value-building $200,000 $200,000

Entry to record sale of real estate (200,000) 0condemned

Entry to record reduction of basis for 0 (500,000)Code Sec.1033

Basis before capitalization of $ 0 $(300,000) $(300,000)construction costs

Assuming that the Company’s federal and state tax rate is 40%, deferred income taxeswould be recorded as follows:

Entry: dr cr

Income tax expense-deferred federal/state (1) 120,000

Deferred income taxes 120,000

(1): $300,000 x 40% = $120,000

The following is an example of a disclosure that would apply to the above:

Note X: Insurance Recovery

In 20X1, the Company incurred a fire at its apartment building located at 120 MainStreet, Nowhere, Massachusetts, which resulted in the building being condemned.

Under its insurance policy, the Company received recovery of costs to reconstructthe building into its condition immediately prior to the fire, and business interruptioninsurance.

The Company received $500,000 as an insurance settlement to reconstruct thebuilding. The insurance recovery, less the carrying amount of the building, resulted in again of $300,000 which is presented in the Other Income section of the statement ofincome. In 20X1, the Company started the reconstruction the building and capitalized$270,000 as part of Construction in Progress at year end.

In addition to receiving the $500,000 insurance settlement, under its businessinterruption insurance policy, the Company received recovery of rental revenue lostduring the construction period, net of certain related costs. The total amount of

¶608


insurance received was $250,000 which is presented in the Other Income section of theincome statement.

COMMENT: In the previous example, the difference between the carryingamount of the building for GAAP and tax purposes results in a temporary differ-ence that creates deferred income taxes. The difference is a byproduct of the basisbeing reduced by the $500,000 of insurance proceeds for tax purposes under theinvoluntary conversion rules in Code Sec. 1033, while being recorded as part of again for GAAP. When the entity reconstructs the building, the costs would becapitalized for both GAAP and tax purposes.

So what will happen if the company does not spend the $500,000 insurance proceedswithin the required two-year (or three-year, in some cases) period required in Code Sec.1033? That Code section requires that the entire amount of the $500,000 insuranceproceeds be spent on qualified replacement property, including reconstruction of thecondemned building, within a two- or three-year qualified period, depending on thecircumstances. If a portion of those funds is not spent on qualified replacement propertywithin the qualified period, the shortfall is taxable and the deferred income taxes on thatportion of the temporary difference set up for the deferred gain would be reversed.

STUDY QUESTION

3. According to ASC 225, an entity may choose how to classify business interruptioninsurance recoveries in the statement of operations________.

a. Without any restrictions

b. As long as the recovery is insignificant

c. As long as that classification is not contrary to existing GAAP

d. As long as the amount is characterized as unusual

¶608

137

MODULE 3: OTHER CURRENTDEVELOPMENTS—CHAPTER 7: Recent ASUs:Going Concern, Debt Issuance Costs, andIntangibles¶701 WELCOMEThis chapter reviews some recent ASUs related to going concern assessment bymanagement, debt issuance costs, internal-use software, and identifiable intangibleassets in a private company business combination.



• Explain changes made to going concern assessment by ASU 2014-15

• Identify one of the criteria that must be met to treat a hosting arrangement asinternal-use software

• Identify how to account for intangible assets under ASU 2014-18’s accountingalternative

¶703 RECENTLY ISSUED ASUsFollowing is a summary of recently issued ASUs.

Recently Issued ASUs 2014 through 2016

ASU No. Description

2014-01 Investments—Equity Method and Joint Ventures (Topic 323): Accountingfor Investments in Qualified Affordable Housing Projects (a consensus ofthe FASB Emerging Issues Task Force)

2014-02 Intangibles—Goodwill and Other (Topic 350): Accounting for Goodwill(a consensus of the Private Company Council)

2014-03 Derivatives and Hedging (Topic 815): Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps—Simplified Hedge AccountingApproach (a consensus of the Private Company Council)

2014-04 Receivables—Troubled Debt Restructurings by Creditors (Subtopic310-40): Reclassification of Residential Real Estate CollateralizedConsumer Mortgage Loans upon Foreclosure (a consensus of the FASBEmerging Issues Task Force)

2014-05 Service Concession Arrangements (Topic 853) (a consensus of the FASBEmerging Issues Task Force)

2014-06 Technical Corrections and Improvements Related to Glossary Terms

2014-07 Consolidation (Topic 810): Applying Variable Interest Entities Guidanceto Common Control Leasing Arrangements (a consensus of the PCC)

2014-08 Presentation of Financial Statements (Topic 205) and Property, Plant,and Equipment (Topic 360): Reporting Discontinued Operations andDisclosures of Disposals of Components of an Entity

2014-09 Revenue from Contracts with Customers (Top 606)

2014-10 Development Stage Entities

¶703



ASU No. Description

2014-11 Transfers and Servicing (Topic 860): Repurchase-to-MaturityTransactions, Repurchase Financings, and Disclosures

2014-12 Compensation—Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That aPerformance Target Could Be Achieved after the Requisite Service Period(a consensus of the FASB Emerging Issues Task Force)

2014-13 Consolidation (Topic 810): Measuring the Financial Assets and theFinancial Liabilities of a Consolidated Collateralized Financing Entity (aconsensus of the FASB Emerging Issues Task Force)

2014-14 Receivables- Troubled Debt Restructurings by Creditors (Subtopic310-40): Classification of Certain Government-Guaranteed MortgageLoans upon Foreclosure (a consensus of the FASB Emerging Issues TaskForce)

2014-15 Presentation of Financial Statements-Going Concern (Subtopic 205-40):Disclosure of Uncertainties about an Entity’s Ability to Continue as aGoing Concern

2014-16 Derivatives and Hedging (Topic 815): Determining Whether the HostContract in a Hybrid Financial Instrument Issued in the Form of a ShareIs More Akin to Debt or to Equity (a consensus of the FASB EmergingIssues Task Force)

2014-17 Business Combinations (Topic 805): Pushdown Accounting (a consensusof the FASB Emerging Issues Task Force)

2014-18 Business Combinations (Topic 805): Accounting for IdentifiableIntangible Assets in a Business Combination (a consensus of the PrivateCompany Council)

2015-01 Income Statement—Extraordinary and Unusual Items (Subtopic225-20): Simplifying Income Statement Presentation by Eliminating theConcept of Extraordinary Items

2015-02 Consolidation (Topic 810): Amendments to the Consolidation Analysis

2015-03 Interest—Imputation of Interest (Subtopic 835-30): Simplifying thePresentation of Debt Issuance Costs

2015-04 Compensation—Retirement Benefits (Topic 715): Practical Expedient forthe Measurement Date of an Employer’s Defined Benefit Obligation andPlan Assets

2015-05 Intangibles—Goodwill and Other—-Internal-Use Software (Subtopic350-40) Customer’s Accounting for Fees Paid in a Cloud ComputingArrangement

2015-06 Earnings Per Share (Topic 260): Effects on Historical Earnings per Unitof Master Limited Partnership Dropdown Transactions (a consensus ofthe FASB Emerging Issues Task Force)

2015-07 Fair Value Measurement (Topic 820): Disclosures for Investments inCertain Entities That Calculate Net Asset Value per Share (or ItsEquivalent) (a consensus of the FASB Emerging Issues

2015-08 Business Combinations (Topic 805): Pushdown Accounting—Amendments to SEC Paragraphs Pursuant to Staff Accounting BulletinNo. 115 (SEC Update)

2015-09 Financial Services—Insurance (Topic 944): Disclosures about Short-Duration Contracts

2015-10 Technical Corrections and Improvements

2015-11 Inventory (Topic 330): Simplifying the Measurement of Inventory

¶703

139MODULE 3 - CHAPTER 7 - Recent ASUs


ASU No. Description

2015-12 Plan Accounting: Defined Benefit Pension Plans (Topic 960), DefinedContribution Pension Plans (Topic 962), Health and Welfare BenefitPlans (Topic 965): (Part I) Fully Benefit-Responsive InvestmentContracts, (Part II) Plan Investment Disclosures, (Part III)Measurement Date Practical Expedient (consensuses of the FASBEmerging Issues Task Force)

2015-13 Derivatives and Hedging (Topic 815): Application of the NormalPurchases and Normal Sales Scope Exception to Certain ElectricityContracts within Nodal Energy Markets (a consensus of the FASBEmerging Issues Task Force)

2015-14 Revenue from Contracts with Customers (Topic 606): Deferral of theEffective Date

2015-15 Interest—Imputation of Interest (Subtopic 835-30): Presentation andSubsequent Measurement of Debt Issuance Costs Associated with Line-of-Credit Arrangements—Amendments to SEC Paragraphs Pursuant toStaff Announcement at June 18, 2015 EITF Meeting (SEC Update)

2015-16 Business Combinations (Topic 805): Simplifying the Accounting forMeasurement-Period Adjustments

2015-17 Income Taxes (Topic 740): Balance Sheet Classification of DeferredTaxes

2016-01 Financial Instruments—Overall (Subtopic 825-10): Recognition andMeasurement of Financial Assets and Financial Liabilities

2016-02 Leases (Topic 842)

2016-03 Intangibles—Goodwill and Other (Topic 350), Business Combinations(Topic 805), Consolidation (Topic 810), Derivatives and Hedging(Topic 815): Effective Date and Transition Guidance (a consensus of thePrivate Company Council)

2016-04 Liabilities—Extinguishments of Liabilities (Subtopic 405-20):Recognition of Breakage for Certain Prepaid Stored-Value Products (aconsensus of the Emerging Issues Task Force)

2016-05 Derivatives and Hedging (Topic 815): Effect of Derivative ContractNovations on Existing Hedge Accounting Relationships (a consensus ofthe Emerging Issues Task Force)

2016-06 Derivatives and Hedging (Topic 815): Contingent Put and Call Optionsin Debt Instruments (a consensus of the Emerging Issues Task Force)

2016-07 Investments—Equity Method and Joint Ventures (Topic 323):Simplifying the Transition to the Equity Method of Accounting

2016-08 Revenue from Contracts with Customers (Topic 606): Principal versusAgent Considerations (Reporting Revenue Gross versus Net)

2016-09 Compensation—Stock Compensation (Topic 718): Improvements toEmployee Share-Based Payment Accounting

2016-10 Revenue from Contracts with Customers (Topic 606): IdentifyingPerformance Obligations and Licensing

2016-11 Revenue Recognition (Topic 605) and Derivatives and Hedging (Topic815): Rescission of SEC Guidance Because of Accounting StandardsUpdates 2014-09 and 2014-16 Pursuant to Staff Announcements at theMarch 3, 2016 EITF Meeting (SEC Update)

2016-12 Revenue from Contracts with Customers (Topic 606): Narrow-ScopeImprovements and Practical Expedients

¶703


¶704 GOING CONCERN ASSESSMENT BYMANAGEMENT- ASU 2014-15

This section addresses ASU 2014-15, Presentation of Financial Statements—Going Con-cern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue asa Going Concern. ASU 2014-15 requires management to perform a going concernassessment of an entity.

With the introduction of ASU 2014-15, now both management and the auditor mustperform their own separate going-concern assessments of the same entity. This sectionaddresses the interrelation of the new GAAP rules in ASU 2014-15 with the auditingstandards found in AU-C 570.

Background

For years, the rules for going concern have been found in auditing literature within AU-C Section 570, The Auditor’s Consideration of an Entity’s Ability to Continue as a GoingConcern (formerly SAS No. 59), which requires an auditor to assess whether an entityhas the ability to continue as a going concern for a reasonable period of time (usuallyone year from the balance sheet date.) Because going concern is a GAAP issue, itbelongs within accounting literature, in addition to auditing standards.

In 2015, Audit Analytics issued a report in which it performed a 15-year study ofgoing- concern opinions. The report, which samples financial statements through 2014,identifies the following trends:

• 2014 going-concern report modifications were at the lowest level over a 15-yearperiod:

Going-concernYear opinions

2014 2,233

2013 2,403

2012 2,565

2011 2,670

2010 2,988

2009 3,102

2008 3,355

Source: Audit Analytics

• 15.8 percent of auditor opinions filed in 2014 contained a going-concern reportmodification. (The highest percentage was 21.1 percent in 2008, and lowest was14.2 percent in 2000.)

• Going-concern report modifications peaked at 3,355 in 2008 and dropped to2,233 in 2014.

Recovery from a Going-Concern Report Modification

Only a small percentage (ranging from five percent to nine percent) of companies thathad going-concern report modifications rebounded with a clean opinion in the subse-quent year. The following table shows the details:

¶704


Number of Clean Opinions in Subsequent Yearto Going-Concern Report Modification

# clean opinions currentCurrent # going concerns year, going % recovery in subsequent

year prior year concern prior year year

2014 2,403 200 8.3%

2013 2,565 188 7.3%

2012 2,670 144 5.4%

2011 2,988 208 7.0%

2010 3,102 276 8.9%

2009 3,355 265 7.9%

2008 3,309 200 6.0%

2007 2,878 253 8.8%

Source: Audit Analytics, as modified by Author.

OBSERVATION: The previous table illustrates a key point with respect togoing-concern report modifications. If such a report modification is made, it can bethe “kiss of death� for a company in the subsequent years. A very low percentageof companies subsequently survive a going-concern report modification.

FASB Issues ASU 2014-15In August 2014, the FASB issued ASU 2014-15, which provides guidance about manage-ment’s responsibility to evaluate an entity’s ability to continue as a going concern and toprovide related disclosures. Previously, no such guidance existed in GAAP.

ASU 2014-15 is effective for the annual period ending after December 15, 2016, andfor annual periods and interim periods thereafter. Early application is permitted.

The objective of ASU 2014-15 is to provide guidance for evaluating whether there issubstantial doubt about an entity’s ability to continue as a going concern and aboutrelated footnote disclosures.

ASU 2014-15 does the following:

• Requires management to make an evaluation of going concern every reportingperiod, including interim periods.

• Defines the term substantial doubt about an entity’s ability to continue as a goingconcern (substantial doubt) as follows:

Substantial doubt about an entity’s ability to continue as a going concernexists when conditions and events, considered in the aggregate, indicate thatit is probable that the entity will be unable to meet its obligations as they

become due within one year after the date that the financial statements are

issued (or within one year after the date that the financial statements are

available to be issued when applicable).

NOTE: The term “probable� is used consistently with its use in Topic 450on contingencies.

• Provides that management should consider the mitigating effect of manage-ment’s plans only to the extent it is probable the plans will be effectivelyimplemented and mitigate the conditions or events giving rise to substantialdoubt.

• Requires certain disclosures when substantial doubt is alleviated as a result ofconsideration of management’s plans

¶704


• Requires an explicit statement in the notes that there is substantial doubt andother disclosures when substantial doubt is not alleviated

• Requires an evaluation for a period of one year after the date that the financialare issued (or available to be issued if a nonpublic entity).

Auditing Standards Board Clarifies its Going-Concern RulesAfter the issuance of ASU 2014-15, there were certain inconsistencies between theGAAP and auditing rules for dealing with going concern. In particular, the one-yearperiod of time for evaluating going concern was different as follows:

• AU-C 570 uses a reasonable period of time as the period for which an auditorshould evaluate going concern. Generally, in practice, that period is one yearfrom the balance sheet date.

• ASU 2014-15 uses a one-year period from the date the financial statements areissued or available to be issued.

Thus, after the FASB issued ASU 2014-15, the GAAP going-concern period extendedseveral months beyond the one-year period used by auditors under AU-C 570.

In response, in January 2015, the Auditing Standards Board (ASB) issued aninterpretation to address conflicting issues related to GAAP’s recently issued ASU2014-15 and going-concern rules found in AU-C 570. The purpose of this audit interpre-tation is to clarify how AU-C 570’s requirements for an auditor addressing goingconcern interrelate with the new GAAP rules found in ASU 2014-15. The auditinginterpretation brings the auditing rules for dealing with going concern in parity with thenew GAAP rules found in ASU 2014-15.

The auditing interpretation states the following:

• When an applicable financial reporting framework (such as GAAP) includes adefinition of substantial doubt about an entity’s ability to continue as a goingconcern, that definition would be used by the auditor when applying AU-Csection 570. For example, if an entity is required to comply with, or has electedto adopt, ASU 2014-15, the definition of substantial doubt about an entity’s abilityto continue as a going concern found in GAAP would be used by the auditor.

• When the applicable financial reporting framework (such as GAAP) requiresmanagement to evaluate whether there are conditions and events that raisesubstantial doubt for a period of time greater than one year from the date of thefinancial statements, the auditor’s assessment of management’s going concernevaluation would be for the same period of time as required by the applicablefinancial reporting framework (such as GAAP). For example, if an entity isrequired to comply with, or has elected to adopt, ASU 2014-15, the auditor’sassessment of management’s going concern evaluation would need to be for thesame period of time as required by ASU 2014-15 (that is, one year after the datethat the financial statements are issued or available to be issued).

• When the applicable financial reporting framework (such as GAAP) providesdisclosure requirements related to management’s evaluation of substantialdoubt, the auditor’s assessment of the financial statement effects under AU-Csection 570 would be based on the disclosure requirements of the applicablefinancial reporting framework (such as GAAP).

OBSERVATION: The period of time that has been used for auditors previ-ously (one year from the balance sheet date) is extended to be one year from thedate the financial statements are either issued (public entities) or available to beissued (nonpublic entities). This change adds a few months to the going concernassessment period for an auditor. It also means that it is important that the auditor

¶704


conclude his or her audit and ensure that the financial statements are issued sothat the one-year period commences. The later the financial statements are issued,the later the one- year going-concern period is extended.

Going Concern in a Review EngagementIn connection with a review engagement, Paragraph .65 of AR-C 90, SSARS No. 21states:

The accountant should consider whether, during the performance of reviewprocedures, evidence or information came to the accountant’s attention indicat-ing that there could be an uncertainty about an entity’s ability to continue asgoing concern for a reasonable period of time.

SSARS No. 21 defines a reasonable period of time to be:

the same period of time required of management to assess going concern whenspecified by the applicable financial reporting framework.

For a GAAP framework, the reasonable period of time is one year from the date thefinancial statements are available to be issued (one year from the review report date).

NOTE: Under SSARS No. 21, for a compilation or review engagement onGAAP financial statements, the accountant should consider whether an uncertaintyexists using the same one-year window that GAAP uses under ASU 2014-15. Thatwindow for a nonpublic entity is one year from the date the financial statements areavailable to be issued.

For a non-GAAP framework (such as tax basis), if that non-GAAP framework does notspecify a period of time for management’s assessment, a reasonable period of time isone year from the date of the financial statements being reviewed (which is one yearfrom the balance sheet date).

The result of the previous analysis is that the one-year going concern assessmentperiod is now the same among GAAP, audit and review engagements.

STUDY QUESTION

1. Prior to the issuance of ASU 2014-15, the going concern assessment was done by__________.

a. The auditor

b. Management

c. Board of directors

d. No assessment is done

¶705 FEES PAID IN A CLOUD COMPUTINGARRANGEMENT-ASU 2015-05ASU 2015-05, Intangibles – Goodwill and Other—Internal-Use Software (Subtopic350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement wasissued in April 2005 as part of the FASB’s Simplification Initiative. The objective of theSimplification Initiative is to identify, evaluate, and improve areas of GAAP for whichcost and complexity can be reduced while maintaining or improving the usefulness ofthe information provided to users of financial statements. The objective of ASU 2015-05

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is to provide guidance to customers about whether a cloud computing arrangementincludes a software license.

BackgroundCurrently, GAAP does not include specific guidance about a customer’s accounting forfees paid in a cloud computing arrangement. Examples of cloud computing arrange-ments include:

• Software as a service

• Platform as a service

• Infrastructure as a service

• Other similar hosting arrangements

The FASB received input from stakeholders that the absence of explicit guidance hasresulted in some diversity in practice and has created unnecessary costs and complexityto evaluate the accounting for those fees. As a result of input, the FASB added guidanceto Subtopic 350-40, Intangibles—Goodwill and Other—Internal-Use Software, to assistentities in evaluating the accounting for fees paid by a customer in a cloud computingarrangement.

The larger question is whether customer fees paid in a cloud computing arrange-ment represent a license to use software or fees for a service contract. ASC 350-40-05-2,Intangibles—Goodwill and Other—Internal-Use Software, defines internal-use software ashaving both of the following characteristics:

• The software is acquired, internally developed, or modified solely to meet theentity’s internal needs.

• During the software’s development or modification, no substantive plan exists oris being developed to market the software externally.

ASC 350-40-35-4 states that internal-use software licensed or acquired is amortized on astraight-line basis unless another systematic or rational basis is more representative ofthe software’s use.

With respect to cloud services, the FASB’s existing guidance is limited and foundin ASC 985-605-55-121 through 55-123, Software-Revenue Recognition; however, thatguidance pertains to revenue received by cloud service providers to determine whetheran arrangement includes the sale or license of software. It does not address theaccounting for cloud services fees paid from the customer’s perspective.

ASU 2015-05 provides guidance to customers about whether a cloud computingarrangement is a license for internal use, or whether it is a service contract:

• If a cloud computing arrangement includes a software license, then the cus-tomer should account for the software license element of the arrangementconsistent with the licensing of internal-use software, which is generally capital-ized and amortized.

• If a cloud computing arrangement does not include a software license, thecustomer should account for the arrangement as a service contract.

ASU 2015-05 does not change GAAP for a customer’s accounting for service contracts.In addition, the guidance in ASU 2015-05 supersedes ASU 350-40-25-16, Intangibles—Goodwill and Other—Internal-Use Software. Consequently, all software licenses withinthe scope of Subtopic 350-40 will be accounted for consistently with other licenses ofintangible assets.

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RulesThe scope of internal-use software found in ASC 350-40-15-4 does not apply to softwarethat a customer obtains access to in a hosting arrangement if it does not meet thefollowing two criteria:

• The customer has the contractual right to take possession of the software at anytime during the hosting period without significant penalty.

• It is feasible for the customer to either run the software on its own hardware orcontract with another party unrelated to the vendor to host the software.

Hosting arrangements that do not meet both of these criteria are considered servicecontracts and do not constitute a purchase of, or convey a license to, software.

NOTE: In determining the two criteria above, the FASB followed the gui-dance found in ASC 985-605, Software, with respect to revenue recognition bysoftware vendors. Those two criteria are: (1) the customer has the contractualright to take possession of the software at any time during the hosting period withoutsignificant penalty, and (2) it is feasible for the customer to either run the softwareon its own hardware or contract with another party unrelated to the vendor to hostthe software.

The term without significant penalty contains two distinct concepts:

• The ability to take delivery of the software without incurring significant cost, or

• The ability to use the software separately without a significant diminution inutility or value.

• ASU 2015-05 supersedes the following paragraph found in ASC 350-40-25-16:

Entities often license internal-use software from third parties. Though Sub-topic 840-10 excludes licensing agreements from its scope, entities shallanalogize to that Subtopic when determining the asset acquired in a softwarelicensing arrangement.

NOTE: The ASU states that some cloud computing arrangements includeone or more licenses to software as well as a promise to provide services, inwhich case the customer should allocate the contract consideration between thelicense(s) and the service element(s).

Effective DateASU 2015-05 is effective as follows:

Public Business Entities. For public business entities, ASU 2015-05 is effectivefor financial statements issued for fiscal years beginning after December 15, 2015, andinterim periods within those fiscal years

Other Entities. For all other entities, ASU 2015-05 is effective for financial state-ments issued for fiscal years beginning after December 15, 2015, and interim periodswithin fiscal years beginning after December 15, 2016.

Early application is permitted for all entities.

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STUDY QUESTION

2. Ralph is a CPA and controller for Company K. K has a cloud arrangement with anoutside vendor under which certain software functions are run and held on the vendor’scloud. Ralph is evaluating how K should account for the costs of the cloud arrangementwhich are paid monthly. The cloud arrangement does not include a software license.How should the cost be accounted for?

a. As internal-use software

b. As a service contract

c. As a prepaid asset

d. Split with a portion expensed and a portion capitalized as a fixed asset

¶706 SIMPLIFYING THE PRESENTATION OF DEBTISSUANCE COSTS - ASU 2015-03ASU 2015-03, Interest—Imputation of Interest (Subtopic 835-30): Simplifying the Presen-tation of Debt Issuance Costs was issued in April 2015 as part of the FASB’s SimplificationInitiative. The objective of the Simplification Initiative is to identify, evaluate, andimprove areas of generally accepted accounting principles (GAAP) for which cost andcomplexity can be reduced while maintaining or improving the usefulness of theinformation provided to users of financial statements.

BackgroundDebt issuance costs are generally considered to be specific third-party incrementalcosts that are directly attributable to issuing a debt instrument, either in the form ofissuing bonds or closing a bank or private loan. Such costs may include:

• Legal fees

• Commissions or financing fees

• Appraisal costs

• Accounting and auditing fees

• Points

• Title insurance

• Any other costs incurred in order to complete specific financing

Debt issuance costs generally exclude internal general and administrative costs andoverhead of the borrowing entity.

Under existing GAAP prior to the effective date of ASU 2015-03, deferred issuancecosts are capitalized as an asset on the balance sheet, and amortized to interest expenseusing the effective interest method.

RulesASU 2015-03 does not apply to the amortization of premium and discount of assets andliabilities that are reported at fair value, or the debt issuance costs of liabilities that arereported at fair value.

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The following elements shall be reported in the balance sheet as a direct deductionfrom the face amount of a note:

• The discount or premium resulting from the determination of present value incash or noncash transactions

• Debt issuance costs related to a note (NEW)

NOTE: The ASU states that similar to a discount or premium resulting fromthe determination of present value in cash or noncash transactions, debt issuancecosts are not an asset or liability separable from the note that gives rise to it.

The discount, premium, or debt issuance costs shall not be classified on the balancesheet as a deferred charge or deferred credit. Amortization of discount or premiumshall be reported on the income statement as interest expense in the case of liabilities oras interest income in the case of assets. Amortization of debt issuance costs shall bereported on the income statement as interest expense.

An entity shall disclose the following on the financial statements or in the notes tothe statements:

• A description of a note (receivable or payable) which shall include the effectiveinterest rate

• The face amount of the note

Effective DateASU 2015-03 is effective as follows:

Public Business Entities. For public business entities, ASU 2015-03 is effectivefor financial statements issued for fiscal years beginning after December 15, 2015, andinterim periods within those fiscal years

Other Entities. For all other entities, ASU 2015-03 is effective for financial state-ments issued for fiscal years beginning after December 15, 2015, and interim periodswithin fiscal years beginning after December 15, 2016.

Early application is permitted for financial statements that have not been previouslyissued.

STUDY QUESTION

3. Company Z has debt issuance costs related to a $5 million loan. How should Zpresent the debt issuance costs on its balance sheet in accordance with ASU 2015-03?

a. Nowhere, as the costs should be expensed as incurred

b. As an asset

c. Netted against the debt

d. As a contra- equity account

¶707 ACCOUNTING FOR IDENTIFIABLE INTANGIBLEASSETS IN A BUSINESS COMBINATION – ASU 2014-18ASU No. 2014-18, Business Combinations (Topic 805): Accounting for Identifiable Intan-gible Assets in a Business Combination (a consensus of the Private Company Council) wasissued in December 2014 to offer an accounting alternative for private companies toelect not to allocate a portion of the acquisition price to certain intangibles other thangoodwill.

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Background

The Private Company Council (PCC) added this issue to its agenda in response tofeedback from some private company stakeholders indicating that the benefits of thecurrent accounting for identifiable intangible assets acquired in a business combinationmay not justify the related costs. By providing an accounting alternative, this ASUreduces the cost and complexity associated with the measurement of certain identifiableintangible assets without significantly diminishing decision-useful information to usersof private company financial statements.

Rules

The ASU, at an entity’s election, applies to all entities except for public business entitiesand not-for-profit entities as defined in the Master Glossary of the FASB AccountingStandards Codification®.

The accounting alternative applies when an entity within the scope of this ASU isrequired to recognize or otherwise consider the fair value of intangible assets as a resultof any one of the following transactions (in-scope transactions):

• Applying the acquisition method under Topic 805 on business combinations

• Assessing the nature of the difference between the carrying amount of aninvestment and the amount of underlying equity in net assets of an investeewhen applying the equity method under Topic 323 on investments—equitymethod and joint ventures

• Adopting fresh-start reporting under Topic 852 on reorganizations

An entity within the scope of ASU 2014-18 that elects to apply the ASU is subject to all ofthe recognition requirements within the accounting alternative. The accounting alterna-tive, when elected, should be applied to all in-scope transactions entered into after theeffective date.

An entity that elects the accounting alternative to a business combination should nolonger recognize goodwill separately from the following:

• Customer-related intangible assets unless they are capable of being sold orlicensed independently from the other assets of the business

• Noncompetition agreements

An entity that elects the accounting alternative in ASU 2014-18 must adopt the privatecompany alternative to amortize goodwill (over a maximum of 10 years straight line) asdescribed in ASU 2014-02, Intangibles—Goodwill and Other (Topic 350): Accounting forGoodwill. However, an entity that elects the accounting alternative in Update 2014-02 isnot required to adopt the amendments in ASU 2014-18.

Effective Date

The decision to adopt the accounting alternative in this ASU must be made upon theoccurrence of the first transaction within the scope of this accounting alternative infiscal years beginning after December 15, 2015, and the effective date of adoptiondepends on the timing of that first in-scope transaction. Early application is permittedfor any interim and annual financial statements that have not yet been made availablefor issuance.

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149

MODULE 3: OTHER CURRENTDEVELOPMENTS—CHAPTER 8: The GradualDemise of Company Pension Plans¶801 WELCOMEThis chapter provides an overview of information and statistics that suggest thatcompany defined benefit pension plans are on the decline. This includes an analysis ofthe significant unfunded liabilities with respect to various pension plans, both from thegovernmental and nongovernmental standpoint. This chapter also discusses how pen-sion plans can influence their total pension liability based on changes in assumptionsused in the pension liability calculation.



• Recognize statistics related to unfunded liabilities prevalent across definedpension plans

• Differentiate between expected rates of return of U.S. pension plans versusthose plans in other countries

• Recognize key requirements prescribed by GASB Statement No. 68

• Differentiate between the various color zones used to assess pension plan health

• Recognize the different types of retirement plans used by nongovernmentalemployees

• Identify the governmental organization responsible for ensuring payment topension plan participants

¶803 INTRODUCTIONOver the past two decades, the costs of maintaining defined benefit pension plansresulted in companies either freezing or eliminating defined benefit plans and replacingthem with defined contribution plans or 401(k) plans. Defined contribution or 401(k)plans offer companies the opportunity to provide their employees with a retirementbenefit, usually at a much lower cost, and with far greater flexibility for several reasons.With a defined contribution or 401(k) plan, a company can more accurately measure theamount of its pension cost because it is based on the amount contributed to the plan, ascompared with the amount of the ultimate benefit paid as in the case of a defined benefitplan. In most defined contribution or 401(k) plans, a company can structure its contribu-tions to be discretionary, thereby allowing it to reduce its pension contribution duringweaker business cycles, and increase it during stronger cycles. And finally, with 401(k)plans, investment risk is shifted from the company to the employees as each employeeis responsible for managing his or her investments.

Now, the next dramatic crisis in the U.S. markets may be the continued deteriora-tion of U.S. defined benefit pension plans. Plans sponsored by corporate, as well as stateand local pensions, are grossly underfunded. The primary reason is one based onsimple math: more benefits are being paid out of the plans than net assets going intothose plans. For example, in January 2016, William Mercer announced that U.S. pensionplan funded status for the S&P 1500 had improved by about $100 billion. In general, a

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higher discount rate reduced liabilities enough to offset longer actuarial lives of planparticipants and declining stock market values. The result is that on December 31, 2015,the pension deficit for the S&P 1500 was $(404) billion, while the deficit was $(504)billion at the end of 2014. Although 2015 had a $100 billion improvement in fundedstatus, the trend does not paint a positive picture for U.S. pension plans.

Any intellectually honest debate must acknowledge that pension liabilities aregrowing faster than the underlying pension assets and on a long-term basis. Even inyears in which the stock market is increasing significantly, those asset value increasescannot offset the continued increases in pension liabilities. These conclusions are truefor all defined benefit plans including single and multi-employer plans.

Nevertheless, even with the introduction of 401(k) plans, many companies haveretained their existing defined benefit plans by either freezing them or continuing tofund them for certain key employee groups such as those in upper management. Beforeaddressing these plans, let’s take a look at a snapshot of where U.S. defined benefitplans fall as of 2015 regardless of what is published:

Funded Status - All U.S. Pension Plans

Unfunded LiabilitiesType of Plan 2015 % Funded Status

Low High

U.S. Corporate Plans:

Multi-employer (union) plans $400 billion $500 billion 46-81%

Single-employer plans 500 billion 700 billion 50-75%

Public-state and local plans (1) 5 trillion 7 trillion 42-60%

Estimated total shortfalls $5.9 trillion $8.2 trillion

(1) Data is based on several recent studies: The range of funded status and percentages varies due tothe discount rates used and other assumptions.Sources: Public Section Pensions: How Well Funded Are They Really? Andrew G. Biggs, State BudgetSolutions, July 2012, adjusted to 2015 and other publications.

In looking at the table above, collectively there is a $5.9 trillion to $8.2 trillion unfundedpension liability across all sectors of private and public entities. The range existsbecause the “true� numbers require one to choose assumptions such as discount rates,expected rates of return, and other variants that significantly affect the unfundedliability. Most commentators believe that the real unfunded liability is closer to theupper amount of $8 trillion due primarily to the fact that sponsors tend to useassumptions that understate pension liabilities. Regardless of whether the shortfall is$5.9 trillion or $8.2 trillion, the numbers are astronomical to the point that the plansponsors (private or public) are in such a dire hole that there is no real way to get outwithout renegotiating pension contracts, which is typically impossible.

Defined benefit plans are being squeezed into extinction by the combination ofstricter GAAP and accelerated funding required by the Pension Protection Act of 2006(PPA), all wrapped within a volatile marketplace. In essence, a large portion of the riskassociated with whether a pension plan is underfunded or overfunded is outside thecontrol of the sponsor company. In general, the sponsor company cannot control thekey factors that drive the funded status of the plan, such as the fair value of the assetsand the discount rate, both essentially driven by macro-market forces.

As of 2016, entities that have defined benefit pension plans face an uphill battle intrying to manage their underlying businesses and comply with funding requirements oftheir pension plans. Because the PPA requires more extensive funding of pension plans,companies with underfunded pension plans must reallocate critical cash flow resourcesfrom their core business operations to fund those plans. It is easy to see why fewcompanies are adopting new defined benefit plans and are instead offering either

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151MODULE 3 - CHAPTER 8 - The Gradual Demise of Company Pension Plans

contributory or noncontributory 401(k) plans where the market risk does not rest withthe sponsor company.

Most of the underfunded defined benefit pension plans exist within more tradi-tional older manufacturing firms with large workforces and strong unions that previ-ously negotiated generous retirement benefits. Examples are the airlines andautomakers, which cannot shed their benefit obligations and are challenged to competewith newer and benefit-lighter companies and foreign companies that do not offer suchbenefits. One example is where, prior to their bankruptcy filing, older airlines such asUnited and U.S. Airways had been burdened with large defined benefit plan obligationsthat newer rivals, such as Jet Blue and Southwest, do not have. In addition to pensionplans, many of the same companies have post-retirement benefit plans, most of whichare grossly underfunded as compared with pension plans because post-retirementbenefit plans are not subject to the funding requirements under ERISA. As a result,most companies fund such post-retirement benefits on a pay-as-you-go basis.

¶804 GAAP RULES FOR DEFINED BENEFIT PLANS - ASC715The accounting for defined benefit plans is prescribed within ASC 715, RetirementBenefits Compensation. ASC 715 requires companies to record on their balance sheetsthe funded status of a defined benefit plan, measured as the difference between the fairvalue of plan assets and the pension benefit obligation. In issuing ASC 715, the FASB’sgoal was to provide greater transparency to pension accounting by requiring companiesto place the funded status of their pension plans on their balance sheet. Under ASC 715,related to the balance sheet, an accrual (liability) is recorded for pension cost. Refer tothe example below.

Assume the following for the year:Service cost $200

Interest cost 100

Expected return on plan assets (50)

Amortization of prior service cost 0

Amortization of (gain) or loss 0

Net periodic benefit cost $250

Entry:

Net periodic pension cost (income statement) 250

Liability for pension benefits 250

An additional liability or asset is also recorded on the balance sheet for the fundedstatus, measured as the difference between the fair value of the plan assets and theprojected benefit obligation (PBO):

Fair value of plan assets $100,000

Projected benefit obligation (PBO) (110,000)

Funded status of plan (under) over $(10,000)

Liability balance (after $250 entry) $8,000

Additional liability recorded 2,000

Adjusted liability on balance sheet $10,000

¶804


It is important to note that a portion of the liability relates to gains or losses and priorservice costs or credits that arise during the period, but that are not recognized ascomponents of net periodic benefit cost of the period. Examples include gains or losses,prior service costs or credits, and transition assets or obligations remaining from theinitial application, which are recorded as part of other comprehensive income andaccumulated other comprehensive income on the balance sheet, net of the related taxeffect.

¶805 SINGLE-EMPLOYER PLANSFor the past decade, a significant number of single-employer defined benefit plans havebeen underfunded. In the 1990s, many companies rode a wave of overfunded status dueto record returns in the stock market coupled with the use of unrealistic plan assump-tions. In the late 1990s, the tide turned and many plans shifted to underfunded status.Most of the shift was driven by the push toward requiring companies to use lowerdiscount rates in valuing their benefit obligations along with softer stock marketreturns. There is also the fact that retirees are living longer than expected, therebyputting pressure on employers to fund benefits over an extended period of time.Following is a table that compares the funded status of the S&P 1500 between 2015 and2014.

S&P 1500 Funded Status

2014 2015

Fair value of plan assets $1.886 trillion $1.800 trillion

Pension obligations 2.390 trillion 2.204 trillion

Funded status $(504) billion $(404) billion

% funded status (assets as percentage of liabilities) 79% 82%

Source: William Mercer, January 2016

Despite volatile equity markets, the funded status improved from $(504) billion in 2014to $(404) billion in 2015. In addition, the total fair value of assets declined by about fivepercent (from $1.886 trillion in 2014 to $1.800 trillion in 2015) as the overall U.S. equitymarkets declined and pension obligations decreased from $2.390 trillion to $2.204trillion. The liability decrease was due, in part, to the change in two conflictingelements:

• The liability decreased because there was an increase in the discount rate fromabout 3.81 percent in 2014 to 4.24 percent in 2015. That rate change wasreflective of an increase in the rate of high-quality corporate bonds. As thediscount rate increases, the liability decreases to account for a lower presentvalue of pension obligations.

• The liability increased because there was an increase in the liability to reflect achange in the longevity assumptions as plan participants are expected to livelonger.

What happened in 2015 represents the continued battle that all defined benefit planshave. As retirees live longer, plans have pressure to drive the increase in asset values topay for those additional benefit liabilities. Only higher interest rates can help reducethose liabilities to offset the increase in the longer retirement periods.

As previously noted, ASC 715 requires that the underfunded status of a definedbenefit plan be recorded as a liability on the balance sheet. A hypothetical combinedbalance sheet of the S&P 1500 on December 31, 2015 would look like this:

¶805


S&P 1500 CompaniesAggregate Balance Sheets

December 31, 2015

(in billions $)

ASSETS:

Deferred tax asset 162

LIABILITIES AND EQUITY:

Liability for pension benefit 404

Common stock XX

APIC XX

Retained earnings XX

Accumulated other comprehensive income (net of taxes) (242)

Total stockholders’ equity XX

DIT asset: $404B x 40% = $162BAccumulated other comprehensive income: $(404)B less DIT asset $162B = $(242)B.

On December 31, 2015, S&P 1500 companies were required to record an aggregateliability for the $(404) billion funded status shortfall. Most of the offset (debit) wasrecorded to accumulated other comprehensive income (equity), net of the tax effect.That $(404) billion of additional liabilities places a strain on those public companieswhen one takes into account that there is a corresponding reduction in stockholders’equity. Consider what happens to the debt-equity ratio of the various S&P 1500companies when the debt numerator is increased by $(404) billion while the denomina-tor is reduced by $(242) billion, net of the tax effect of $162 billion.

STUDY QUESTIONS

1. Which of the following statements is correct with respect to defined benefit pensionplans?

a. A company can more accurately measure the amount of its pension cost.

b. A company can structure its contributions to be discretionary.

c. Investment risk is shifted from the company to the employee.

d. The amount of its pension cost is based on the amount of the ultimate benefitpaid.

2. Which of the following is a result of ASC 715?

a. It changes the rules for defined contribution pension plans.

b. It requires companies with defined benefit plans to record on their balancesheets a portion of the plan liabilities.

c. It introduces greater transparency of plan disclosures.

d. It addresses whether post-retirement health benefit plans should beconsolidated.

¶806 UNDERFUNDED MULTI-EMPLOYER PENSIONPLANS AND THE LOADED PISTOLNot only are single-employer plans in trouble, but the next U.S. taxpayer bailout mayinvolve pension plans; namely multi-employer pension plans, mostly involving union

¶806


employees. A multi-employer plan is a pension or other postretirement benefit planwhich has the following characteristics:

• There are two or more unrelated employers that contribute, usually pursuant toone or more collective bargaining agreements.

• Assets contributed by one particular employer may be used to provide benefitsto employees of other participating employers since assets contributed by anemployer are not segregated in a separate account or restricted to providebenefits only to employees of that employer.

• Employers are jointly and severally liable for the plan obligations so that ashortfall in the plan may have to be funded by any and all of the employers.

• The plan usually has a withdrawal or exit fee if an employer seeks to withdrawfrom the plan.

One of the most pervasive issues related to multi-employer plans is that employers arejointly liable for the plan liabilities. That means if one company fails to pay its obliga-tions, the remainder employers must pay the shortfall. It is sometimes referred to as the“last man standing� principle. If there are five employers in a multi-employer plan andfour are defunct, the fifth remaining employer is liable for the entire underfunded statusof the plan.

Related to this subject, Credit Suisse published a report entitled, Crawling Out ofthe Shadows, in which it evaluated the pension data of 1,354 pension plans of large andsmall to medium-cap U.S. companies. Although the report is four years old, theconclusions reached are still relevant in 2016, and demonstrate chronic problems thatexist with multi-employer pension plans. The results were staggering and are notedbelow.

• Multi-employer plans cover approximately 10 million U.S. workers (seven per-cent of the workforce), and have been partially insured by the Pension BenefitGuarantee Corporation (PBGC).

• Multi-employer plans were $428 billion underfunded (46 percent funded) withmost of the underfunding belonging to companies outside the S&P 500.

- Based on the most recent Form 5500 filings, multi-employer plans reported anunfunded liability of only $(101) billion as compared with Credit Suisse’s recon-structed liability of $(428) billion.

- The underfunding was heavily weighted in the construction, transports, super-markets, and mining industries.

• Companies could continue to be adversely affected by the extreme underfund-ing by increased contribution requirements, difficult labor negotiations, higherwithdrawal liabilities, and weaker credit ratings.

• Using the Form 5500 filings, multi-employer plans played games with theactuarial computations of plan funded status, using an average expected rate ofreturn on assets of 7.5 percent, which is significantly higher than the actualreturn on investments and significantly higher than the rate for high-qualitycorporate bonds, which is the required rate.

• The pension shortfalls affected not only large cap companies, but also mid- tosmall-cap ones.

Credit Suisse recomputed the funded status of 1,354 of a total of 1,459 multi-employerplans that are insured by the PBGC using fair value instead of actuarial value. Inaddition, the discount rate used to compute the pension liabilities was 4.7 percent(return on high-grade corporate bonds), instead of 7.5 percent used in the actuarialcomputations. Refer to the results of the recomputed analysis below.

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Funded Status of Multi-Employer Plans(Based on 1,354 sample)

In billions

Reported Actuarial RecomputedBasis by

(Form 5500) Credit Suisse

Assets $426 $360

Liabilities (527) (788)

Net position $(101) $(428)

% funded-per sampled plans 81% 46%

Estimated net position of all U.S. multi-employer plans $(454)

Source: Credit Suisse

When Credit Suisse recalculated the funded status of the selected multi-employer plans,the above-noted chart illustrates that the true funded status was a negative $(428) billioninstead of the reported $(101) billion. Moreover, the percentage funded status wasactually 46 percent and not the reported 81 percent.

The Pension Protection Act of 2006 established zones for evaluating the fundedstatus of pension plans, using the following system:

Color Zone % Funded Additional contributions

Green (Healthy) > 80% funded None

Yellow (Endangered) 65-80% or Funding Improvement Plan

required:

the plan has an accumulated • Must increase futurefunding deficiency or is expected contributions and/or reduceto have one during any of the next future pension benefit accrualssix years to improve the plan’s health, and

• Funded status must improve byone third within 10 years.

Orange 65-80% and Funding Improvement Plan(Seriously Endangered) required:

the plan has an accumulated • Must increase futurefunding deficiency or is expected contributions and/or reduceto have one during any of the next future pension benefit accrualssix years to improve the plan’s health, and

• Funded status must improve byone-fifth within 15 years.

Red (Critical) < 65% funded Rehabilitation Plan required:

• Must increase futurecontributions and/or reducefuture pension benefit accrualsto improve plan’s health

• Can also cut previously earned“adjustable� benefits (e.g., earlyretirement)

• Plan must emerge from criticalcondition within 10 years.

Source: Credit Suisse

Credit Suisse reported that the top 10 multi-employer plans were significantly un-derfunded as compared with the reported funded status in their Form 5500 filings:

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Top 10 Largest Multi-Employer Pension PlansFunded Status

Reported % funded Recomputed % funded(Form 5500) (Credit Suisse)

Central States, Southeast and Southwest Areas Pension 63% 39%Plan

Western Conference of Teamsters Pension Plan 89% 56%

Central Pension Fund of the IUOE & Participating 86% 45%Employers

Participating Employers National Electrical Benefit Fund 86% 47%

Boilermaker-Blacksmith National Pension Trust 80% 44%

1199 SEIU Health Care Employees Pension Fund 100% 50%

I.A.M. National Pension Plan 108% 58%

New England Teamsters & Trucking Industry Pension 52% 25%

Plumbers And Pipefitters National Pension Fund 68% 37%

Bakery & Confectionery Union & Industry International 87% 46%Pension Fund

Source: Credit Suisse based on Form 5500 Filings

COMMENT: The previous chart illustrates that once the pension plan statusof the sample plans was recomputed at fair value by Credit Suisse, only fourpercent of plans were in the Green Zone (healthy), while 88 percent were in theRed Zone (critical).

The reader may recall the battle between Hostess brands and its unions, and theattempts for management and the unions to settle on a new contract. What most peopledid not realize at that time is that there was no way that a deal could be struck underany circumstances. Hostess had 12 unions, 372 pieces of collective bargaining agree-ments, and 42 multi-employer plans involving 18,500 employees. Approximately one-third of the multi-employer plans to which Hostess contributed were among the most

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underfunded plans in the United States. This included the Bakers union which had $22million of the total $100 million of annual contributions to pension plans. The Baker’sunion pension plan had a significant underfunded status. See summary below:

Assets $4 billion

Liabilities (7 billion)

Unfunded status $(3 billion)

Plan activity:

Contributions received annually $155 million (15% paid by Hostess)

Benefits paid out annually (550 million)

Annual shortfall $(395 million)

Participants in plan:

Current retirees 70%

Current workers 30%

Conclusion: 30% of current workers pay for the benefits of 70% retirees.

With Hostess funding 15 percent of the contributions to the Baker’s union pension plan,coupled with the annual shortfall in funding, there was no way that Hostess couldcontinue to stay in the Baker’s pension plan. Under the multi-employer plans, Hostesswas jointly and severally liable for any unfunded plan status, which potentially exposedHostess to the entire $3 billion shortfall. Moreover, if Hostess withdrew from thevarious pension plans, it would have been exposed to a $2 billion pension withdrawalliability.

The result was that Hostess filed Chapter 11 and used the protection of thebankruptcy code to shed most of its pension obligations. In Chapter 11, Hostess saved$22 million per year in contributions to the Baker’s pension plan and terminated allsingle-and multi-employer plans. This resulted in Hostess eliminating $2 billion ofwithdrawal liabilities for 42 multi-employer plans and shifting the burden of its singleemployer plans (2,300 employees) on to the PBGC. In addition, it also shifted theburden of its multi-employer plans (covering 16,000 employees) onto other employersand a portion to the PBGC. Those other employers included Kraft Foods, SafewayStores, Kroger, and BBU, among others, and eliminated its private equity owners’potential exposure to the unfunded pension liabilities, as those owners were deemedpassive investors.

COMMENT: In recent years, private-equity funds have effectively used bank-ruptcy to eliminate pension withdrawal liabilities in cases involving Friendly’s IceCream, Eddie Bauer, Hostess (discussed above), and Delphi Automotive.

¶807 THE PENSION PLAN ASSUMPTIONSMANIPULATION GAMEAs can be noted, defined benefit plans are underfunded based on use of distortedassumed rates of return. For more than a decade, companies and their actuaries haveartificially underreported pension liabilities by using a discount rate that is inflated. If acompany wishes to manipulate its funded status, all it has to do is change threefundamental assumptions used in the calculation of the pension liability. This includes:

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• The discount rate used to present value the pension liability

• The expected rate of return on assets which reduces pension cost

• The compensation growth rate

The general rule is that the higher the discount rate and expected rates of return, thelower the pension liability and the lower the pension cost. In addition, the lower thecompensation growth rate, the lower the pension liability and lower the cost. Therefore,if you want to understate pension liabilities and pension cost, you use a higher discountrate, a higher expected rate of return, and a lower compensation growth rate.

The discount rate is used to compute the present value of the projected benefitobligation. Several of the components of the pension cost used to record the currentaccrual to the pension liability are measured based on either the discount rate orexpected rate. This includes the service cost, interest cost, and the expected return onplan assets. The service cost reflects a compensation growth rate so that if that rate isreduced, the service cost is recorded to pension cost and the corresponding pensionliability is reduced. Refer to the following table:

Component of NetPeriodic Cost Recorded to

Pension Liability Definition Rate Used

Service cost Amount by which the pension obligation Discount Rate (DR)increases as a result of employee serviceduring the current yearCompensation growth rate is reflected in theservice cost.Benefits x discount rate

Interest cost Amount by which the benefit obligation Discount Rate (DR)increases due to passage of timeBeginning PBO x discount rate

Expected return on plan Expected amount of returns generated by Expected Rate of Returnassets plan assets during the accounting period. (ERR)

Determined based on historical returnsBeginning FV of assets x Expected Rate ofReturn

Amortization of prior service The portion of cost related to plan adoption NAcost or amendment

Amortization of (gain) or loss Changes in assumptions, actual versus NAexpected return on plan assets, etc.

Net periodic benefit cost(current year accrual)

The following is a T account that illustrates the effect of these three rates on theprojected benefit obligation (PBO):

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Therefore, the way to minimize the pension liability is summarized below:

The discount rate is used to present value the benefits and compute the pensionliability, referred to as the projected benefit obligation. The expected (long-term) rate ofreturn is used to compute a portion of annual pension cost and actually reduces totalpension cost. ASC 715 defines the discount rate as the rate used to measure theprojected benefit obligation, and the service and interest cost components of netperiodic pension cost. ASC 715 further states that the discount rate should reflect therate at which the pension benefits could be effectively settled. This is the rate of returnneeded on a bond investment made today to fund future benefit obligations. Addition-ally, the discount rate is determined at the measurement date and an employer may usethe current rates of return on high-quality fixed-income investments currently availablewhose cash flows match the timing and amount of expected benefit payments. The rateof return on high-quality fixed-income investments consists of the rate of return on AAand AAA corporate bonds, with maturities that match the pension obligation payouts.Typically, rates of returnon AA bond funds with maturities ranging from 10-20 yearsare used. Examples of funds include Merrill Lynch U.S. Corporate AA 15 years +fund,

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Merrill Lynch U.S. Corporate AA/AAA 10 years fund, and Citigroup Pension LiabilityIndex Fund.

The determination of the assumed discount rates is separate from the determina-tion of the expected return on plan assets whenever the actual portfolio of plan assetsdiffers from the hypothetical portfolio of high-quality fixed income investments (AA andAAA rated corporate bonds).

ASC 715 notes that the objective of selecting a discount rate is to measure thesingle amount that, if invested at the measurement date in a portfolio of high-qualitydebt instruments, would provide the future cash flows necessary to pay the pensionbenefit obligations when due. Theoretically, that single amount would equal the currentmarket value of a portfolio of high-quality zero coupon bonds whose maturity dates andamounts would be the same as the timing and amount of the expected future benefitpayments. Because cash inflows would equal cash outflows in timing and amount, therewould be no reinvestment risk in the yields to maturity of the portfolio.

However, in other than a zero coupon portfolio, such as a portfolio of long-termdebt instruments that pay semiannual interest payments or whose maturities do notextend far enough into the future to meet expected benefit payments, the assumeddiscount rates (the yield to maturity) need to incorporate expected reinvestment ratesavailable in the future. Those rates shall be extrapolated from the existing yield curve atthe measurement date. Assumed discount rates shall be reevaluated at each measure-ment date. If the general level of interest rates rises or declines, the assumed discountrates shall change in a similar manner.

On the other hand, expected (long-term) rate of return is the interest rate used tocompute the expected return on plan assets, which is a reduction in pension cost. ASC715 prescribes that the expected rate of return should reflect the average rate ofearnings expected on the funds invested or to be invested to provide for the benefitsincluded in the projected benefit obligation. In addition, appropriate considerationshould be given to the returns being earned by the plan assets in the fund and the ratesof return expected to be available for reinvestment.

As previously noted, GAAP requires the discount rate used to compute the pro-jected benefit obligation to be based on the current rate of return on high-quality fixed-income investments consisting of the rate of return (yield) ranging between AA- andAAA-rated corporate bonds. Because AA-rated bonds have a higher yield, typically mostcompanies use a higher AA-rate, which minimizes the pension benefit obligation. Thefollowing table compares the average discount rate used by SEC companies with therange of yields that was being generated for AA- and AAA-rated bonds in the same year.

Annual Discount Rates Versus Bond Returns

Discount Rate Used for Returns on Pension Funds AA and AAA- Rated Bonds

End of the Year (a) (c)

2015 4.22% 3.9% (b)

2014 3.81% 3.7% (b)

2013 4.83% 4.6% (b)

2012 4.02% 3.6%

2011 4.79% 4.4%

2010 5.44% 5.5%

2009 5.82% 5.7%

2008 6.35% 5.8%

(a) Milliman 100 Pension Funding Index(b) Moody’s AAA Bond Yield December of each respective year(c) Blend of rates based on Merrill Lynch AA 15-year, AA/AAA 10-year, and Citigroup bond indexfunds

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COMMENT: In the previous table, the discount rate used in 2009 to 2010 wasrelatively close to the range of rates actually generated on AA and AAA-ratedcorporate bonds. Then, in 2011 and 2012, there was a spread in which the discountrate used was slightly higher than the rate of return on bonds Similarly, thediscount rates for 2014 (3.81 percent) and 2015 (4.22 percent) were higher than therates of return for bonds of 3.7 percent and 3.9 percent, respectively.

For those companies that used a higher discount rate, the incentive is obvious in thatthe higher rate results in a lower liability. While one might conclude that a smallelevation in the discount rate (4.22 percent versus 3.9 percent) is insignificant, thatsmall increase in the discount rate has a significant effect on the amount of the liability.The general rule is that for every one percent increase in the discount rate, the pensionliability drops by about 15 percent. If the rate increase is only .32 percent (4.22 percentversus 3.9 percent), the result is a potential reduction in the liability of about fivepercent. A company with a $1 billion pension liability can reduce that amount by $50million with a corresponding reduction in pension cost. So now the reader can under-stand that if a company can increase its discount rate by a small fraction, it cansignificantly understate the pension liability.

The discount rate used to measure pension liabilities is supposed to be the rate thatwould be generated if the entity hypothetically purchased a risk-free asset at themeasurement date, and generated enough investment return to fund future pensionpayouts. Because pension obligations are guaranteed, the liability is risk-free so that, intheory, the investment purchased at the measurement date should also be a risk-freeasset. If the risk-free rate were the valid rate, the rate of the 10-year U.S. Treasury bondswould be used which would result in rates as follows:

U.S. Treasury Bond RateDate 10 years

December 31, 2015 2.27%

December 31, 2014 2.17%

December 31, 2013 3.03%

December 31, 2012 1.91%

December 31, 2011 1.97%

December 31, 2010 3.39%

December 31, 2009 3.73%

The reason cited by the FASB and others as to why a risk-free discount rate is not usedto compute the pension liability is because there is risk that exists between maturities.That is, it is virtually impossible to match maturities of U.S. Treasury bonds with thecash requirements to fund pension obligations. Therefore, as each investment were tomature, there would be risk associated with being able to repurchase the investments atthe same interest rates. Thus, the investments required to be purchased at the measure-ment date could not be purchased without having some interest-rate risk. Consequently,using a risk-free discount rate would not be realistic because an entity would not havethe ability to purchase U.S. Treasury bonds with maturities that identically match thedue dates of the pension obligation payments.

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To recap, the expected rate of return is the interest rate used to compute theexpected return on plan assets, which is a reduction in pension cost. ASC 715 states that“the expected rate of return must reflect the average rate of earnings expected on thefunds invested or to be invested to provide for the benefits included in the projectedbenefit obligation.� In determining the expected rate of return, consideration must begiven to the mix of actual investments and their returns. Companies have an incentive tokeep the expected rate of return as high as possible. The higher the rate, the higher theexpected return on plan assets, which reduces the PBO and pension cost.

Comparison of ERR to Actual Rate of Return, By Year

Expected Rate of Return(ERR) Actual Rate of

End of the Year Used for Pension Funds Return

2015 7.5% 1.9%

2014 7.5% 9.9%

2013 7.5% 11.2%

2012 7.5% 11.7%

2011 7.8% 5.9%

2010 8.0% 12.8%

2009 8.1% 14.0%

2008 8.1% (18.8)%

2000 to 2014 average (a) 6.0%

Source: Milliman 100 Pension Funding Index, 2014 Corporate Pension Funding Study, December 2015

(a) Published average return for 2000 to 2012, adjusted by the author to reflect the effect of 2013-2015

Notice from the table above that the average ERR used by U.S. pension funds was about7.5 percent in 2015 while the actual return for that year was only 1.9 percent. That wouldsuggest that the expected rate of return was actually too low. Moreover, even thoughthe average ERR for 2015 was 7.5 percent, more than 50 percent of the entities used anERR of eight percent to nine percent.

Based on ASC 715, the ERR must be the rate of return that the plan expects to earnover a long period of time, taking into account the mix of investments in the plan on themeasurement date. Although the ERR used in 2015 was around 7.5 percent, one mustlook closer to reach a conclusion that the 7.5 percent rate might actually be too high,not too low. The actual rate of return on assets for the U.S. plans was only six percentfrom 2000 to 2015, well below 7.5 percent and the 2015 rate of return of 1.9 percent wasreflective of a deterioration in the U.S. stock market. Furthermore, in order to justify a7.5 percent expected (long-term) rate of return, an entity would have to have a heavyweighting of investments in equities and higher-risk investments.

From one survey, it appears that the typical investment mix followed by most of themajor U.S. pension plans in 2015 was:

Equities 40%

Fixed income (bonds, etc.) 40%

Other investments 20%

100%

Source: Milliman 100 Pension Funding Index, 2015 Corporate Pension Funding Study

That means a company that uses an expected ERR of eight percent to nine percent isassuming that the long-term return that will be generated on a long-term basis will beeight percent to nine percent based on the 40 percent/40 percent/20 percent blend ofassets.

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A survey of expected rates of return used by pension plans in other countriesindicates that U.S. companies use ERRs that are significantly higher than other coun-tries. Consider the following list based on 2015 data:

Expected Rates of Return By Country

ERR Usedin 2015

Country Pension Plans

Canada 5.57%

Germany 3.92%

Japan 2.69%

Netherlands 3.22%

Switzerland 2.75%

UK 5.74%

United States 6.99%

Source: 2015 Global Survey of Accounting Assumptions for Defined Benefit Plans, Towers Watson

What the above table shows is that U.S. pension plans are using expected rates of returnthat are significantly higher than those used by any other major country. A higherexpected rate of return reduces the pension liability as previously noted.

As previously stated, if a company wishes to manipulate the funded status of itspension plan, all it has to do is change three fundamental assumptions used in thecalculation of the pension liability. The last assumption that can be altered is thecompensation growth rate. When a company computes the service cost component oftotal pension cost, it must reflect into the computation any growth in compensation thataffects the pension payout. If a company wants to keep its pension benefit obligationdown, one way is to reduce the growth rate of compensation that is reflected in thecomputation of the service cost component of pension cost that is recorded as part ofthe pension liability.

On average, companies include an average salary increase of about two to fivepercent per year in the computation of the service cost component. If, instead, theassumption only reflects a one percent increase, the service cost component and, inturn, pension liability would be reduced. Although it is impossible to truly estimate thecompensation growth rate over a long period of time, in general, a rate of two to fivepercent is consistent with what most companies should be using in their pensioncomputations.

COMMENT: Because the assumptions reflected in the compensation ofpension liabilities of a defined benefit plan are quite subjective and can dramaticallychange the overall outcome, it is imperative that any stakeholder in a pension planevaluate the key assumptions used in measuring the pension liability and fundedstatus.

GAAP requires that a company disclose the discount rate, expected rate of return, andcompensation growth rate. Using 2015 market information, those rates should be in thefollowing ranges:

Assumption Typical Range of Acceptable Rate

Discount rate 3.5% to 4.0%

Expected return on assets Not greater than 7%

Compensation growth rate 2 to 5%

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If a company’s disclosure of its pension plan assumptions deviates from those noted inthe above table, there is a question as to whether appropriate pension plan assumptionshave been followed.

It is clear that some companies are manipulating the discount rate and expectedrate of return to keep the PBO down. If this is the case, why are pension liabilitiesincreasing? Companies may be trying to keep pension liabilities down by keeping boththe discount rate and expected rate of return high, but that action is simply not enough.A key reason for the increase in pension liabilities is that life expectancy is increasing.The longer the life expectancy of pension retirees, the greater the benefits that will haveto be paid out and, in turn, have to be present-valued to compute the PBO. Lifeexpectancy at birth has risen from about 65 years in 1950 to more than 76 years now.Life expectancy will surpass 90 years by year 2100.

Using a recent actuarial table, a future male retiree who is currently age 50 will liveuntil 81, while in 1996, that same male would have been expected to live until age 77.That means there are an additional four years of pension benefits to be paid to that oneemployee, and that additional cost must be reflected in the pension liability, on apresent value basis. That trend is likely to continue. Consequently, regardless of thegrowth of pension assets, defined benefit pension plans are going to be a challenge tofully fund. The math of having too many pensioners living too long makes it virtuallyimpossible for companies to be able to keep their defined benefit pension plans solvent.

Pension plan trustees are concerned that lower interest rates, coupled with pen-sioners living longer, will bankrupt their defined benefit plans. And the truth is that theycould be correct. The good news is that in the next few years, when the Federal Reservelikely stops artificially pushing rates down, the effects of the Fed’s quantitative easing(e.g., printing money) may translate into higher inflation and interest rates. If thathappens, the underfunded status of many of the U.S. pension plans could be reversed inone swoop simply because the discount rate increases. Consider that if interest ratesrise significantly, so will expected rates of return and discount rates. With higher rates,pension liabilities will be reduced so that the funded status may become positive. Untilinterest rates rise, it will be virtually impossible for most pension plans with anunfunded status to reverse themselves.

STUDY QUESTIONS

3. Which of the following identifies a conclusion reached with respect to the CreditSuisse report on multi-employer plans?

a. Multi-employer plans continue to be overfunded due to a strong stock market.

b. Multi-employer plans are slightly underfunded by about 10 percent.

c. Multi-employer plans are grossly underfunded at about 46 percent.

d. Multi-employer plans became overfunded in recent years due to significantchanges in actuarial assumptions.

4. Which color zone does a pension plan fall into as defined by the Pension ProtectionAct if it is 86 percent funded?

a. Yellow

b. Green

c. Orange

d. Red

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5. Which of the following is a way in which an entity can reduce the pension liability ofits defined benefit pension plan?

a. Use a higher discount rate

b. Use a higher compensation growth rate

c. Use a higher actual rate of return

d. Use a lower expected rate of return

6. Which of the following is an example of an investment which can be used as thediscount rate for measuring the projected benefit obligation?

a. Rate of a U.S. Treasury instrument

b. Rate for a AA-rated corporate bond

c. Rate for a junk bond

d. Rate for an overnight repo

¶808 STATE PENSION PLANS- AN ACCIDENT WAITINGTO HAPPENThe state pension plan saga continues and the story does not get any better. Accordingto a report from State Budget Solutions, issued in November 2014, state employeeretirement plans are in big trouble. The report notes that through 2013 plan years, all 50state plans are underfunded by a total of $4.7 trillion, have a funded ratio of 36 percent,and have a shortfall averaging $15,000 per capita. The breakout of the funded status all50 state plans is as follows:

Total assets $2.7 trillion

Plan liabilities (7.4) trillion

Shortfall- underfunded $(4.7) trillion

The numbers are far worse than the previous year’s numbers of $4.1 trillion un-derfunded with a funded status of 39 percent. The report measured pension liabilities bymarket valuation using a 15-year Treasury rate of 2.74 percent instead of expected ratesof return used by pensions that are in the seven to nine percent range. Using the states’own erroneous assumptions, the unfunded liabilities were only $1 trillion instead of $4.7trillion. A summary of the worst states follows:

Largest Shortfalls-State Pension Plans

Market Unfunded LiabilityState Actuarial Assets Liability* Funding Ratio Unfunded Liability Per Capita

Alabama $29,419,597 $94,436,581 31% $65,016,984 $13,450

Alaska $9,830,274 $39,700,280 25% $29,870,006 $40,639

Arizona $31,866,927 $90,652,039 35% $58,785,112 $8,871

Arkansas $21,504,868 $61,485,975 35% $39,981,107 $13,512

California $476,133,354 $1,230,182,696 39% $754,049,342 $19,671

Illinois $95,040,320 $426,619,820 22% $331,579,500 $25,740

New York $238,027,500 $545,959,988 44% $307,932,488 $15,670

Texas $190,832,179 $486,932,011 39% $296,099,832 $11,196

Ohio $152,370,215 $441,974,046 34% $289,603,831 $25,028

New Jersey $86,122,541 $286,272,593 30% $200,150,052 $22,491

Florida $131,680,615 $315,080,836 42% $183,400,221 $9,380

Pennsylvania $85,215,151 $267,049,559 32% $181,834,408 $14,235

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Largest Shortfalls-State Pension Plans

Market Unfunded LiabilityState Actuarial Assets Liability* Funding Ratio Unfunded Liability Per Capita

Michigan $57,209,849 $193,562,650 30% $136,352,801 $13,779

Massachusetts $42,974,758 $147,019,968 29% $104,045,210 $15,545

ALL 50 STATES $2,679,831,466 $7,416,319,293 36% $4,736,487,827 $15,052

* Market value based on use of 15-year Treasury rate of 2.734%Source: State Budget Solutions, November 2014

In June 2012, GASB issued Statement 68, Accounting and Financial Reporting forPensions, to make some changes to the pension rules for public pension plans. Therules were effective in fiscal years beginning after June 15, 2014. GASB 68 made thefollowing changes to public pension plans:

• It requires governments that participate in defined benefit pension plans toreport in their statement of financial position the funded status (projectedbenefit obligation less the fair value of assets).

• It requires immediate recognition of annual service cost and interest on thepension liability and immediate recognition of the effect on the net pensionliability of changes in benefit terms.

- Other components of pension expense will be recognized over a closed periodthat is determined by the average remaining service period of the plan members(both current and former employees, including retirees).

• Discount rate: GASB 68 provides for use of a blended discount rate to computethe present value of the projected benefit obligation. The discount rate is a blendof expected rate of return and yield on tax-exempt 20-year bonds. The discountrate is computed by using a long-term expected rate of return for that portion ofthe plan assets that is expected to be secured by plan assets. For example, if 60percent of the pension liability is expected to be funded by plan assets, 60percent of the expected rate of return should be used to compute the discountrate.

• Use a yield or index rate on tax-exempt 20-year, AA-or-higher rated municipalbonds for that portion of the pension liability that is not expected to be securedby plan assets. For example, if 40 percent of the pension liability is expected notto be funded by plan assets, 40 percent of the yield on tax-exempt bonds shouldbe used to compute the discount rate.

• It requires employers to present more extensive disclosures and requiredsupplementary information.

COMMENT: The changes that GASB 68 made have a significant effect notonly on state and local governments, but also on any institutions (colleges anduniversities) that participate in state pension plans. Such institutions have to recordtheir share of the state pension plan liability.

As to the two discount rates, under GASB 68, the overall discount rate declines becauseof the use of the two rates. To the extent that the plan has assets to fund the PBO, thehigher expected rate of return will be used. The excess PBO, for which there is notexpected to have plan assets to pay for the benefits, a lower rate based on the 20-yearAA or higher rated municipal bond will be used.

EXAMPLE: Assume the Town of Brokesville has a funded status of 50percent (fair value of assets/PBO). Also assume the current rate on 20-year AA-rated municipal bonds is 3.5 percent and that the expected rate of return on planassets is eight percent based on the existing investment mix. Under GASB 68, 50percent of the pension liability is discounted using the eight percent expected long-

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term rate, as that is the portion of the liability for which there will be sufficientpension assets to pay for plan obligations. The remaining 50 percent is discountedusing the AA-rated municipal bond rate of 3.5 percent as noted below.

8% x 50% = 4.00%

3.5% x 50% = 1.75%

Weighted discount rate 5.75%

Although a rough calculation, the discount rate (which, under previous GASB rules,would have been based on the expected rate of return of eight percent), declines toabout 5.75 percent. That decline of greater than two percent would significantly increasethe pension liability, but is far short of the discount rate that should be used based on anAA-rated bond which is about 3.5 percent in the previous example.

¶809 CAN COMPANIES AFFORD TO OFFERADEQUATE PENSIONS AND OTHER BENEFITS IN THEFUTURE?The trend is toward companies offering more modest pension and retirement plans inthe future as the cost to maintain them is simply too great. According to the PBGC(Source: PBGC, 2014 Annual Management Report, November 2014), defined benefitplan terminations were 83 in 2014 as compared with 111 in 2013, compared to only 67terminations back in 2008. Additionally, the number of employees enrolled in definedbenefit plans covered by the PBGC has gradually declined from year to year to about 40million in 2014. Now, only seven percent of private sector employees are part of definedbenefit plans, down from 62 percent in 1980.

A short time ago, the AICPA published the results of a survey conducted of morethan 3,000 members in both publicly and privately held companies. The results notedthat 74 percent of respondents stated that U.S. companies cannot continue providingemployees with pensions that adequately cover their retirement years and 54 percentindicated that the erosion of benefits would hurt recruiting and retention efforts.Furthermore, 57 percent believe rising healthcare costs are the biggest barrier to acompany’s ability to offer pension benefits and 30 percent stated the pressures tocompete in the marketplace outweigh the pressures to provide retirement benefits.Finally, 65 percent of respondents offer 401(k) plans with matching contributions and 59percent believe that Americans need to educate themselves about retirement savingsstrategies.

¶810 WHO PAYS FOR THE FUNDING SHORTFALLS INPENSION PLANS?Is it the U.S. Government as part of a bailout, the PBGC, state and local taxpayers, or allthree? With $6 to 8 trillion of pension liability shortfalls related to single and multi-employer corporate plans, and state and local plans, it is doubtful that the relatedsponsors will be able to fund these shortfalls. For corporate plans, the first line ofdefense in funding deficient pension plans (including multi-employer and single-em-ployer plans) is the PBGC. The PBGC bails out defunct defined benefit pension plans,including single- and multi-employer plans. But who will bail out the PBGC? For thepast few years, the PBGC has had negative funding positions and significant exposurefor future bailouts. Nevertheless, Congress will likely have to subsidize the PBGC in thenext few years.

Part of the problem is that the PBGC only guarantees benefits up to about $13,000per employee, per year, which is not enough to fund most of the overall shortfalls.

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September 30(In billions)

PBGC Status: 2014 2015

Assets $90.0 B $87.7 B

Liabilities (151.8) B (164.0) B

Net position $(61.8) B $(76.3) B

Possible exposure $184 million $238 million

Source: PBGC, 2015 Annual Management Report, November 2015

At September 30, 2015, the PBGC had exposure to fund potentially defunct pensionplans in the amount of $238 million, consisting of $218 million related to single-employer plans, and $20 billion related to multi-employer plans (2015 Annual Manage-ment Report, Pension Benefit Guarantee Corporation, November 2015) Those amountsdo not reflect future claims that could occur from grossly underfunded plans that arecategorized in the red zone. A large portion of the $184 million of possible exposure in2014 was concentrated in the manufacturing and transportation industries.

On one side, the PBGC is simply not receiving the cash flow needed to function asfewer plans are available to pay it fees. On the other side, companies, in particular thosein older established, union-based businesses, have learned how to play the bankruptcygame as a method to eliminate two burdens; one is union contracts and the other is thelarge underfunded pension obligations. Upon filing bankruptcy, companies can shift aportion of the pension shortfall to PBGC with no recourse. Classic examples of suchstrategies have previously occurred in the airline industry.

There is no surprise that Congress has been lobbied by the various unions forCongress to approve a bailout of the pension liabilities for multi-employer plans. Sincemost of the multi-employer plans involve union employees, the union lobbies areextensive. There have been several bills proposed in Congress that would provide forthe U.S. taxpayer to fund or guarantee the funding of the multi-employer plan deficitsafter the PBGC pays its share of the losses. To date, nothing has passed. Similardiscussions exist with public plans. In addition, Congress may be required to bail outthe PBGC for other shortfalls related to single-employer plans.

Consider a rough computation of the total underfunded obligation that could existwith multi-employer plans along with the PBGC, which could require U.S. taxpayerbailout:

Multi-employer plans: (in billions)

Funding deficiency $(428) billion x 88% in the Red Zone $(377)

Total potential exposure $(377)

Assets in PBGC 88

Net exposure to bailout $(289)

In looking at the above table, a few observations can be noted. If one considers thatportion of the multi-employer plans that is in Red Zone status (88 percent have a fundedstatus of less than 65 percent), the net potential exposure to bail out the plans could be$377 billion. Additionally, the PBGC has only $88 billion of assets as of its 2015 financialstatements to pay for $377 billion of potential losses, leaving the PBGC short by about$289 billion. Add to that number any potential shortfall in single-employer plans. Theresult is that the PBGC has insufficient assets to pay for exposure to losses and mayhave to be bailed out by Congress.

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The largest shortfall of defined benefit pension plans actually rests with state andlocal pension plans, which have a shortfall of about $5 to $7 trillion. There is simply noway that the state and local governments will be able to fund $5 to 7 trillion. Don’t besurprised if state and local municipals seek a bailout of their plans from Congress.

¶811 TRENDS IN PENSIONS AND COMPENSATIONThe recent cutback in defined benefit pension and postretirement plan benefits is part ofa larger trend toward a reduction in overall compensation and employee benefits. Ingeneral, companies are looking for ways to trim overall compensation costs. Considerthese statistics: (Monthly Labor Review, Bureau of Labor Statistics, December 2015).

• 25 million people will leave the work force through 2020.

• The average age of a U.S. worker exceeds age 41, with more than 20 percentmore than age 55.

• The median age will increase to 43 by 2020, with more than 25 percent expectedto be older than age 55. At that time, baby boomers will be between the ages of56 and 74.

To put the age in perspective, the average age of a U.S. worker was only 34 in 1980.With a soft economy, companies are taking specific action toward reducing employerretirement plan benefits thereby shifting that benefit to employee IRAs. One reportstated that total retirement benefits from all U.S. employer retirement plans decreasedfrom 7.8 percent of pay in 2002 to approximately 6 percent in 2015 with a continueddownward trend (Watson Wyatt)

Based on the most recently published information, assets in retirement plans ofnon-governmental employees are approximately at the following levels:

Assets in Retirement Plans for Non-Governmental Employees

2015

2015 assets 2015 1996Plan type in plans* % %

IRAs $7.3 trillion 44% 31%

401(k)-defined contribution plans 6.5 trillion 39% 36%

Defined benefit plans 2.8 trillion 17% 33%

$16.6 trillion 100% 100%

Source: 2015 information: The U. S. Retirement Market, Investment Research Institute, December 2015.1996 information: Flow of Funds Report, Federal Reserve.* Consists of third quarter 2015 data.

There has been a continued shift from defined benefit plans to 401(k) plans and, in turnfrom 401(k) plans to individual IRA accounts. This move in assets from corporate-related accounts to individual accounts is a trend because companies have to cut ever-growing employee benefits. As presented in the previous table, the highest percentageof assets in retirement funds lies in IRAs (44 percent) with defined benefit plans havingthe smallest percentage (17 percent). This shift is profound when compared with thepercentages in 1996 when the percentages were equally divided among the three typesof plans. Clearly, the shift to IRAs is a prime example of companies having to reducehigher retirement costs from the entity to the individual responsibility.

The same trend is occurring with other employee benefits. With respect to healthinsurance, companies are being forced to shift more of the financial burden ontoemployees. A survey published by Mercer Human Resource Consulting asked thisquestion to employers about health care costs:

¶811


How is your company responding to rising health care costs?

Higher co-payments 64%

Increase deductibles 61%

Increase employee contribution to premiums 60%

Health savings accounts/reimbursable plans 45%

Wellness/disease prevention programs 40%

Switch providers for lower rates 39%

Disease-management programs offered 18%

Reduce scope of coverage 12%

Purchase health care jointly with other businesses 8%

Use more contract labor to avoid cost 7%

Notice that the first three responses represent a shift in the financial burden toemployees. The above survey does not reflect the impact of Obamacare which is likelyto further reduce benefits provided by employers.

Unfortunately, regardless of the type of pension plan used by retirees and prospec-tive retirees, there is a significant shortfall in the amount of pension assets as comparedwith what individuals will require in the future to retire. Consider the following, some ofwhich is provided by the Employee Benefits Research Institute:

• The average employee contributes 6.4 percent of his or her paycheck to a401(k), much less than 10 percent minimum that is recommended.

• Boomers and Gen Xers have an aggregate retirement income shortfall of $4.3trillion.

• Shortfall is defined as: Amount needed to retire, less amount in savings andSocial Security benefits.

¶812 NEW DEFINED BENEFIT PLAN MORTALITY TABLESIn October 2014, the Society of Actuaries (SOA) released new mortality tables found inRP-2014 and a new mortality improvement scale referred to as MP-2014. These newtables directly impact company defined benefit plan liabilities. According to SOA, thenew mortality tables are based on about 10.5 million life-years of exposure and morethan 220,000 deaths, submitted from a total of 123 private and public/federal pensionplans.

The mortality assumptions currently used to value most retirement programs inNorth America were developed from data that are more than 20 years old (UP-94 andRP-2000), which are based on mortality experience with base years of 1987 and 1992,respectively.

The new mortality tables reflect expanded life expectancies which will be reflectedin actuarial computations of plan obligations. Life expectancies of 65-year olds in theUnited States have increased from 84.6 years to 86.6 years for men, and 86.4 years to88.8 years for woman. For companies with significant defined benefit pension and otherpost-employment benefit (OPEB) obligations, longer life expectancies will probablysignificantly increase the plan obligations. An average of two years of future benefitpayments will have to be added to the plan obligation liability on sponsor financialstatements.

COMMENT: The immediate income statement effect will be minimal asGAAP permits the adoption of the new tables to be amortized into net income overseveral years.

¶812


The new mortality assumptions and longer life expectancies will likely also result inhigher contribution requirements, benefit restrictions, lower balance sheet fundedstatus (assets minus liabilities will be lower), higher lump-sum payouts, and higherPBGC variable rate premiums.

One important question is must companies use the new mortality tables in comput-ing plan obligations for GAAP financial statements? Not necessarily. U.S. GAAP doesnot require a plan sponsor to use a particular mortality table so that sponsors ultimatelymake the decision as to which assumptions they use in their financial statements tomeasure a plan’s defined benefit obligation and net periodic benefit cost. Instead, plansponsors make their own decisions with respect to assumptions used for their financialstatements as long as they use the “best estimate� available. That said, most planactuaries, accountants and auditors choose to use the actuary tables, in particular thenewly issued RP-2014, because it represents the most recently issued mortality informa-tion available.

For pension funding purposes, although the IRS did not include the new RP-2014information in its tables for 2014 and 2015, the IRS is expected to reflect it in its tablesfor 2016. Therefore, for GAAP purposes, some companies may try to hold onto the old(and less expensive) actuary tables through 2015 plan years based on the argument thatthey do not want to use the new tables until the IRS uses them in 2016. For manyactuaries, accountants and auditors, they may not want to wait until 2016 and may forcetheir clients to use the new tables starting in 2014 plan years.

In February 2015, the AICPA issued a Technical Practice Aid (TPA) entitled,Section 3700, Pension Obligations .01 Effect of New Mortality Tables on NongovernmentalEmployee Benefit Plans (EBPs) and Nongovernmental Entities That Sponsor EBPs, toaddress the applicability of the new mortality tables to sponsors of pension plans. Anexcerpt is included below.

Technical Practice Aid (TPA) entitled, Section 3700, Pension Obliga-tions .01 Effect of New Mortality Tables on Nongovernmental Em-ployee Benefit Plans (EBPs) and Nongovernmental Entities ThatSponsor EBPs

[February 2015]

Inquiry: Nongovernmental EBPs and nongovernmental entities that spon-sor EBPs (sponsoring entities) incorporate assumptions about participants’mortality in the calculation of the benefit liability for financial reportingpurposes. Professional associations of actuaries occasionally publish up-dated mortality tables and mortality improvement projection scales (collec-tively referred to as mortality tables for purposes of this Technical Questionand Answer) to reflect changes in mortality conditions based on recenthistorical trends and data. Established actuarial companies also may de-velop mortality tables based on other information and assumptions.

For financial reporting purposes, how and when should nongovern-mental EBPs and nongovernmental sponsoring entities considerthese updated mortality tables if their financial statements have notyet been issued at the time the updated mortality tables arepublished?

Reply: Nongovernmental EBPs and nongovernmental sponsoring entitiesshould consider the specific requirements of generally accepted accountingprinciples (GAAP), which require the use of a mortality assumption thatreflects the best estimate of the plan’s future experience for purposesof estimating the plan’s obligation as of the current measurement date

¶812


(that is, the date at which the obligation is presented in the financialstatements).

In making this estimate, GAAP requires that all available informationthrough the date the financial statements are available to be issued shouldbe evaluated to determine if the information provides additional evidenceabout conditions that existed at the balance sheet date.

FASB Accounting Standards Codification (ASC) 855-10-55-1 specifies thatinformation that becomes available after the balance sheet date (but beforethe financial statements are available to be issued) may be indicative ofconditions existing at the balance sheet date when that information is aculmination of conditions that existed over a long period of time.

Updated mortality tables are based on historical trends and data that goback many years; therefore, the existence of updated mortality conditions isnot predicated upon the date that the updated mortality tables are pub-lished. Management of a nongovernmental EBP or a nongovernmentalsponsoring entity should understand and evaluate the reasonableness of themortality assumption chosen, even when assisted by an actuary acting as amanagement’s specialist, and document its evaluation and the basis forselecting the mortality tables it decided to use for its current financialreporting period. A management’s specialist is defined in paragraph .05 ofAU-C section 500, Audit Evidence (AICPA, Professional Standards), as anindividual or organization possessing expertise in a field other than account-ing or auditing, whose work in that field is used by the entity to assist theentity in preparing the financial statements.

Many defined benefit pension plans present plan obligations as of thebeginning of the plan year, as allowed under FASB ASC 960-205-45-1.Although this presentation is before the balance sheet date, it represents ameasurement of an amount that is presented in the financial statements thatshould reflect management’s best estimate of the plan’s mortality and otherassumptions. The assumptions used to estimate the plan’s obligation shouldbe evaluated based on all available information through the date the finan-cial statements are available to be issued, including determining whetherupdated mortality conditions existed as of the date the obligation ispresented in the financial statements (that is, the beginning of the year).

Auditors are required to evaluate the competence, capabilities, and objectiv-ity of a management’s specialist; obtain an understanding of the work of thatspecialist; and evaluate the appropriateness of that specialist’s work as auditevidence for the relevant assertion. Considerations may include evaluatingthe relevance and reasonableness of significant assumptions and methodsused by that specialist. Refer to paragraphs .08 and.A35–.A49 of AU-Csection 500 and the “Using the Work of a Specialist� section in chapter 2,“Planning and General Auditing Considerations,� of the AICPA Audit andAccounting Guide Employee Benefit Plans, for further guidance. In addition,the auditor is responsible for evaluating subsequent events under AU-Csection 560, Subsequent Events and Subsequently Discovered Facts (AICPA,Professional Standards). That section requires the auditor to obtain suffi-cient appropriate audit evidence about whether events occurring betweenthe date of the financial statements and the date of the auditor’s report thatrequire adjustment of, or disclosure in, the financial statements are appropri-ately reflected in those financial statements in accordance with the applica-ble financial reporting framework. [Issue Date: February 2015.]

¶812


Although GAAP does allow a plan sponsor to choose its plan assumptions as long asthey are the best estimates available, the SEC has been a bit more forceful and lettingcompanies know they expect those companies to use the new mortality tables. In hisremarks made in December 2014 during the 2014 AICPA National Conference onCurrent SEC and PCAOB Developments, the SEC’s T. Kirk Crews made the followingcomments:

“Given plan sponsors have historically utilized the SOA’s mortality data andthat data has been updated, the [SEC] staff does not believe it would beappropriate for a registrant to disregard the SOA’s new mortality data indetermining their best estimate of mortality. Finally, management shouldconsider the guidance in Subtopic 715-20 and disclose the impact of mortalityto the extent it results in a significant change in the benefit obligation.”

Those comments suggest that the SEC expects SEC companies to use the new tables inapplying its “best estimate� of mortality assumptions.

It is also interesting to consider the impact of the using the new mortality tables on2014 pension plans If an entity uses the new mortality tables for 2014, they are addingan average of two years of pension payments in the computation of their pensionobligations. That amount is likely to be significant. The following also identifies some ofthe impacts of the new mortality tables:

• Tower Watson noted that it estimates that the funded status of the 400 largestU.S. company pension plans declined by $72 billion as a result of using the newmortality table assumptions in 2014.

Overall funded status of the top 400 companies declined from 89 percent to 80 percentdue to mortality table changes and a decline in interest rates (Longer Lives HitCompanies With Pension Plans Hard—Firms’ balance sheets will have to reflect highercosts, Wall Street Journal, February 2015).

As to individual companies, some had more significant impacts on their liabilitiesthan others: (Long lives pinching pension plan funds, Bloomberg News, February 2015)

• General Motors’ pension liability increased by $2.2 billion due to mortality tablechanges, out of an overall increase of $3.6 billion.

• AT&T’s pension and retirement-benefit obligations increased by $1.5 billion in2014.

• Kimberly-Clark’s pension obligations increased by about $2.5 billion.

• General Electric estimated that the new mortality assumptions could cause itsretiree obligations to increase by $5 billion.

• Dow Chemical Co.’s pension liabilities increased by $750 million stemmed fromnew mortality table estimates.

In addition to the increases in obligations due to use of the new mortality tables, for2014 plan years, companies experienced additional pension obligations due to a declinein interest rates. Thus, for 2014, U.S. companies with pension plans incurred sizeabledeterioration in their funded status due to a one-two punch created by use of the newmortality tables coupled with a decline in interest rates.

¶813 U.S. PENSION PLANS ARE MOVING FROMEQUITIES TO BONDSAs previously discussed in the last section, pension liabilities are increasing in part,because interest rates (and thus discount rates) have declined. One reason for thedecline is that the AA and AAA-rated bond interest rates have decreased. Moreover, theoverall discount rates are declining because sponsors no longer wish to hold such a

¶813


high percentage of assets in risk equity investments. As a result, the shift is movingtoward bonds and, consequently, a lower discount rate. A lower discount rate yields ahigher pension obligation. Companies are increasing their holdings in long-term bondsfor several reasons. With bonds they can more closely match returns with futurepension commitments, bonds offer less risk from the volatility of the stock market, andsponsors are anticipating that bonds will offer a higher interest rates in the future if theFederal Reserve follows up on its warning that it is likely to increase interest rates.

For the first time since 2003, large pension funds hold more bonds than equities.The 50 largest pension plans in the S&P 500 invested 43 percent of their assets in bondsand 37 percent in stocks last year. In 2013, the split was 42 percent in debt and 41percent in equities the year before, according to a new report from Goldman SachsAsset Management (Yield Watch: Corporate Pensions Shift to Bonds, CFO Journal,WSJ, April 2015, based on a report issued by Goldman Sachs Asset Management). Thisis in stark comparison to 2003 where pensions held only 30 percent in bonds versus 61percent in equities.

STUDY QUESTIONS

7. The results of an AICPA survey of more than 3,000 of its members in both publiclyand privately held companies show that what percent of respondents do not believe thatU.S. companies can continue providing employees with pensions that adequately covertheir retirement years?

a. 30 percent

b. 54 percent

c. 65 percent

d. 74 percent

8. Which of the following is likely to occur based on the new mortality assumptions?

a. There will be lower pension contribution requirements.

b. Funded status will be lower.

c. There will be lower lump-sum payouts.

d. There will be lower PBGC variable rate premiums.

9. Recently, sponsors of company pension plans have been shifting more to which ofthe following types of investments?

a. Bonds

b. Equities

c. Mutual funds

d. Index funds

CPE NOTE: When you have completed your study and review of chapters 6-8, whichcomprise Module 3, you may wish to take the Final Exam for this Module. Go toCCHGroup.com/PrintCPE to take this Final Exam online.

¶813


175

¶10,100 Answers to Study Questions¶10,101 MODULE 1—CHAPTER 11. a. Incorrect. Under existing GAAP, in order for a lease to qualify as a capital lease,the present value of the minimum lease payments must be equal to or exceed 90% ormore (and not 10%) of the fair value of the asset.

b. Incorrect. Under existing GAAP, in order for a lease to qualify as a capital lease, thelease term must be at least 75 percent of the remaining useful life of the leased asset.

c. Correct. Under current GAAP, ASC 840, Leases divides leases into twocategories: operating and capital leases. Under existing GAAP, if there is abargain purchase at the end of the lease, this is one of the criteria which woulddefine the lease as a capital lease.

d. Incorrect. Under existing GAAP, if there is a transfer of ownership, the leasequalifies as a capital lease.

2. a. Correct. The new standard uses the right-of-use model under which a leaseobligation is recorded at the present value of cash flows with the recording of acorresponding right-of-use asset.

b. Incorrect. Operating leases are part of existing GAAP and have nothing to do withthe new lease standard.

c. Incorrect. The term “capital lease� is part of existing GAAP and is not used in thenew model even though the new model does capitalize assets and liabilities.

d. Incorrect. The concept of “true lease� is found in taxation and not in GAAP.

3. a. Incorrect. The new standard will not require the company to record a lease assetand liability for a short-term lease of 12 months or less. This will be required for leaseterms of more than 12 months.

b. Incorrect. The new standard will permit, but not require, that the company record ashort-term lease as an operating lease.

c. Correct. If the lease is 12 months or less, a lessee will be able to elect torecord the lease as an operating lease, or will also be allowed to record the leaseasset and liability, similar to other leases. In accordance with the right-of-usemodel, a lessee will recognize assets and liabilities for any leases that have amaximum possible lease term of more than 12 months.

d. Incorrect. The new standard does address these leases, and gives options as to howto deal with them.

4. a. Incorrect. Total expense (interest and amortization) on the lessee’s incomestatement will be higher, not lower, in the earlier years of new leases.

b. Incorrect. There will be a positive (not negative) shift to cash from operations fromcash from financing activities in the statement of cash flows.

c. Incorrect. In most cases, total expense for GAAP will differ from total expense forincome tax purposes resulting in deferred income taxes being recorded.

d. Correct. The lessee’s EBITDA may increase as there is a shift from rentexpense to interest and amortization expense. Interest and amortization are notdeducted in arriving at EBITDA while rent expense under existing operatingleases is deducted.

¶10,101


5. a. Incorrect. The new standard is not likely to expand leases because those leaseswill have lease obligations that have to be recorded on the lessee’s balance sheet.

b. Incorrect. Shorter, not longer, leases will be the trend so that smaller liabilities arerecorded on the lessee’s balance sheet.

c. Correct. Tenants in single-tenant buildings with long-term leases may chooseto buy because they already have to record lease obligations that are similar tothe debt they will have to record in a purchase.

d. Incorrect. The status quo is not likely to be the case given the enormity of theimpact of the new standard on company balance sheets.

6. a. Incorrect. GAAP depreciation under a purchase may be lower, not higher,because the useful life used to depreciate the purchased asset is usually longer than thelease term used to amortize the lease.

b. Correct. The useful life used to depreciate an asset under a purchase is likelyto be longer than the lease term used to amortize a lease, thereby resulting inlower depreciation with a purchase than amortization with a Type A lease.

c. Incorrect. There is no indication that the amounts will be the same, as the termsused for depreciation will differ than those for amortization,

d. Incorrect. Even if the option periods are included in the lease term, that term will belower than the useful life of the purchase. Thus, depreciation will always be lower thanamortization.

¶10,102 MODULE 1—CHAPTER 2

1. a. Incorrect. Fair value is not used in inventory valuation.

b. Correct. For companies using LIFO, market value is defined as replacementcost subject to a ceiling and a floor.

c. Incorrect. Net realizable value is the ceiling for market but is not market. Market isreplacement cost, subject to a ceiling and a floor. The ceiling is defined as net realizablevalue.

d. Incorrect. Normal profit is not market. Normal profit is merely a reduction made tonet realizable value to compute the floor. The floor represents the lowest amount formarket.

2. a. Incorrect. Normal profit is not part of the formula for net realizable value. Instead,normal profit is used to adjust net realizable value to a floor in determining lower of costor market for LIFO and retail inventory methods.

b. Correct. Costs of completion, disposal and transportation are deducted fromestimated selling price to compute net realizable value.

c. Incorrect. Fixed costs are not part of the formula for net realizable value. Instead,costs that are adjustments represent certain variable costs.

d. Incorrect. Any discounts and allowances are considered disposal (selling) costs andare deducted, not added, to estimated selling price to compute net realizable value.

3. a. Incorrect. Inventory is measured at net realizable value only if cost is higher thannet realizable value. If, however, cost is lower than net realizable value, inventory wouldbe measured at cost.

¶10,102

177ANSWERS TO STUDY QUESTIONS - Module 1 - Chapter 3

b. Correct. ASU 2015-11 requires FIFO inventory to be measured at lower ofcost and net realizable value. However, LIFO inventory is still measured usingthree possible outcomes.

c. Incorrect. Although inventory might be measured initially at cost, the subsequentmeasurement is not.

d. Incorrect. The ASU does not use the term “fair value� and instead uses the term“net realizable value.�

4. a. Incorrect. Because the test requires use of net realizable value, it is not possiblefor J to perform the test on individual items in raw materials basis. In particular, thosematerials ultimately become part of finished goods inventory so that the test should beperformed on total inventory.

b. Correct. The best way to perform the test is to perform it on total inventory thatincludes raw materials, work-in-process, and finished goods inventory. In doingso, net realizable value can be computed based on the finished goods inventory.

c. Incorrect. Because FIFO is used, the previous lower of cost or market method,which uses replacement cost, is no longer available under ASU 2015-11.

d. Incorrect. Because the test requires use of net realizable value, it is not possible forJ to perform the test on individual items in raw materials basis. While performing thetest on total inventory would be a reasonable approach, the company should onlyperform the test on individual items in raw materials if the total inventory approachresults in an impairment of inventory.

5. a. Incorrect. The amendments would have required a revaluation of the LIFO layerswhich could impact the amount of the LIFO reserve but certainly not an elimination ofit.

b. Incorrect. Existing GAAP already requires use of replacement cost under theexisting lower of cost or market computation. The ASU makes no changes to thatrequirement for LIFO inventories.

c. Correct. One particular criticism of the ASU is that it would result in signifi-cant costs particularly for the transition into the ASU due to allocating anyprevious write-downs to inventory layers.

d. Incorrect. Existing GAAP requires use of normal profit in computing the flooramount of market. The ASU requires entities that use LIFO to continue existingpractice. Thus, there would not be a new requirement to use normal profit because it isalready used in existing GAAP.

¶10,103 MODULE 1—CHAPTER 31. a. Incorrect. In reviewing the rules in ASC 740, the probable threshold is not usedin determining whether a valuation account is required. The probable threshold is usedin the contingency rules.

b. Incorrect. The reasonably possible threshold is not used in determining whether avaluation account is required. Reasonably possible is a term used in the contingencyrules, not the valuation account.

c. Correct. ASC 740 uses the more-likely-than-not (more than 50-percentprobability) threshold to determine whether a valuation account is required. If itis more like than not that a portion or the entire deferred tax asset will not berealized, a company is required to record a valuation account against the de-ferred tax asset.

¶10,103


d. Incorrect. ASC 740 and GAAP, in general, does not use the term “highly likely� as athreshold for determining whether a valuation account is required. ASC 740 specificallyuses a different term when addressing this topic.

2. a. Incorrect. Estimated future taxable income should exclude the reversal oftemporary differences and carryforwards.

b. Correct. Tax-planning strategies that a company would implement to utilize anexpiring NOL is one example of future income. An example of a tax-planningstrategy is switching from a tax-exempt to a taxable investment. This in turncreates future taxable income.

c. Incorrect. Reversal of existing taxable temporary differences is a source of futureincome, but it is based on the assumption that taxable income is zero and not thattaxable income is greater than book income.

d. Incorrect. A current year tax loss does not create future income.

3. a. Correct. If the federal rate were to be reduced, all deferred tax assets thatwere previously recorded at a higher 35 percent tax rate would have to beadjusted downward to reflect the lower tax benefit that would be received infuture years.

b. Incorrect. Deferred tax assets would not be adjusted upward as a result of loweringthe corporate tax rate. However, if rates increase, the deferred tax assets should beadjusted upward.

c. Incorrect. There would be an effect on deferred tax assets with respect to thelowering of corporate tax rates. Depending on the change in the corporate tax rate (i.e.adjusted up or down), this would have an effect on the deferred tax assets of companies.

d. Incorrect. A lowering of the corporate tax rate would not have an impact on thevaluation account used for deferred tax assets. Depending on the change in thecorporate tax rate (i.e. adjusted up or down), this would have an effect on the deferredtax assets of companies, which would be adjusted directly to the deferred tax asset andnot the valuation account.

4. a. Incorrect. The classification is not based on the estimated reversal date unlessthe deferred tax liability does not relate to an asset or liability.

b. Correct. GAAP requires the classification of the deferred tax liability (or asset)follow the classification of the related asset or liability that caused the temporarydifference.

c. Incorrect. GAAP does not provide for always classifying the deferred tax liability (orasset) as long-term.

d. Incorrect. There is no GAAP requirement that a deferred tax liability or asset alwaysbe classified as current.

5. a. Incorrect. This is not the Correct federal tax rate that should be used to recordthe deferred tax liability. This percent represents the current maximum U.S. federalcorporate tax rate.

b. Incorrect. This is not the Correct federal tax rate that should be used to record thedeferred tax liability. The 25-percent rate is the rate on taxable income between $50,000and $75,000.

c. Correct. The average graduated tax rate on $100,000 of taxable incomeshould be used, which is 22 percent.

¶10,103


d. Incorrect. This is not the Correct federal tax rate that should be used to record thedeferred tax liability. Thirty-four percent is the tax rate on taxable income within the$75,000 and $100,000.

6. a. Incorrect. NOL carryforwards cannot be carried forward indefinitely. They canonly be carried forward for 20 years.

b. Correct. Section 179 deductions can be carried forward indefinitely. Thisdeduction relates to an election to recover all or part of the cost of certainqualifying property, up to a limit, by deducting it in the year the property isplaced in service.

c. Incorrect. Capital loss carryforwards cannot be carried forward indefinitely. Theycan only be carried forward five years from the loss year.

d. Incorrect. Charitable contributions can only be carried forward five years for thatportion that exceeds 10 percent of taxable income, without regard to the deduction forthe contribution and other items.

7. a. Incorrect. Pharmaceuticals is an industry that would be adversely affected by areduction in tax rates. Commercial banks would be another industry that would beadversely affected by a reduction in tax rates.

b. Incorrect. Biotechnology is an industry that would be adversely affected by areduction in tax rates. Auto components would be another industry that would beadversely affected by a reduction in tax rates

c. Incorrect. Financial companies would be adversely affected by a reduction in taxrates.Computer hardware and software manufacturers would be other industries thatwould be adversely affected by a reduction in tax rates.

d. Correct. Oil and gas exploration companies would benefit from a reduction intax rates. Other winners would include utilities and energy sectors; electric, gas,and water utilities; and transportation companies.

8. a. Incorrect. The worldwide average top corporate income tax rate is 22.6 percent,not 35 percent. The U.S. corporate tax rate is 35 percent.

b. Incorrect. Europe has the lowest, not highest, top corporate income tax rate. Itsaverage corporate tax rate is 18.6 percent.

c. Incorrect. By region, Africa has the highest, not lowest, top corporate income taxrate. Its highest average tax rate is 29.1 percent.

d. Correct. The United States has the third highest general top marginal corpo-rate income tax rate in the world. It is only exceeded by Chad and the UnitedArab Emirates.

9. a. Correct. The United Arab Emirates has the highest corporate tax rate. Itstax rate is 55 percent.

b. Incorrect. Australia does not have the highest corporate tax rate. Its tax rate is 30percent which is lower than countries such as the United States, India, France, andJapan.

c. Incorrect. The United States does not have the highest corporate tax rate. Itsmaximum corporate tax rate is 35 percent, which is lower than both Chad and theUnited Arab Emirates.

d. Incorrect. Switzerland has one of the lowest corporate tax rates at 8.5 percent. Itstax rate is lower than many countries such as Ireland, Sweden, Israel, and Austria.

¶10,103



1. a. Incorrect. Under current practice, materiality is not determined by the investor orother third party, but is typically determined by the company or auditor.

b. Incorrect. In practice, materiality is typically determined using an arbitrary thresh-old such as five percent of income or a percentage of total assets, not a statistical,computed threshold.

c. Correct. The Report suggests that the materiality threshold should be deter-mined through the eyes of the investor, for whom the financial information isissued. That threshold is based on what will affect investors’ decisions.

d. Incorrect. The Report suggests that both quantitative and qualitative factors shouldbe considered in determining materiality, and it should not be based on an arbitraryquantitative threshold.

2. a. Incorrect. The Study does deal with shelf life of disclosures and does not suggestthat such disclosures get replaced after one year. In fact, rarely does the disclosure getremoved.

b. Correct. One key point noted in the Study is that once a disclosure is added tothe notes, it is rare that the disclosure is omitted in future financial statementsor filings. The result is that excess disclosures accumulate in the notes overseveral years.

c. Incorrect. There is no evidence that the disclosure converts to a qualitative version.

d. Incorrect. The Study did state that companies are concerned that an auditor orregulator will require a company to retain a disclosure. However, there is no evidencethat a regulator will make a company change a disclosure.

3. a. Incorrect. The business section is identified as one of the possible categories.According to the sample financial statements, the business section would consist ofoperating and investing transactions.

b. Incorrect. The proposal would include a financing section. According to the samplefinancial statements, the financing section would include debt and financingtransactions.

c. Incorrect. The proposal would include an income tax section that would be reflectiveof activity related to all income taxes.

d. Correct. There is no debt section identified. Instead, debt activity would bepart of the financing section.

4. a. Incorrect. The term “cash equivalents� would be eliminated.

b. Incorrect. Although “cash and cash equivalents� is a term used under the currentstatement of cash flows, the FASB does not recommend that it be continued.

c. Correct. The FASB wants to eliminate the term “cash equivalents” so that thestatement of cash flows reconciles down to cash only.

d. Incorrect. Cash and short-term investments is not a category recommended by theFASB.

5. a. Incorrect. Collection of receivables increases cash from operating activitieswhich, in turn, affects free cash flow.

¶10,104


b. Correct. Purchasing equipment through long-term debt has no impact on freecash flow. This is considered a capital expenditure.

c. Incorrect. Purchasing equipment with accounts payable which is outstanding at yearend does, in fact, ultimately result in the cash flow impacting free cash flow. When theaccounts payable is paid in the following period, the change in accounts payable is anadjustment to cash from operating activities, thereby affecting free cash flow.

d. Incorrect. Preferred stock dividend payments are deducted from net income toarrive at free cash flow. Thus the payments directly impact free cash flow.

6. a. Incorrect. Day’s supply in inventory is inventory divided by net sales times 365.

b. Incorrect. Days payable outstanding consists of accounts payable divided by netsales times 365.

c. Correct. Days in working capital consists of the sum of the working capitalcomponents divided by net sales times 365.

d. Incorrect. There is no formula for days left in the sales cycle.

7. a. Incorrect. Companies had more than “very little� excess working capital.

b. Correct. The REL working capital study showed that U.S. companies hadabout $1 trillion in excess working capital due to inefficient working capitalmanagement.

c. Incorrect. In 2014, the number of days in payables was higher (46) than the numberof days in receivables (36).

d. Incorrect. Days in working capital decreased from about 39 in 2009 to 33 in 2014.

8. a. Incorrect. A symptom that exists in companies with poor working capitalmanagement techniques is an increase in inventory obsolescence, which suggestsexcess inventory maintained over current demand for that inventory.

b. Incorrect. An increase, not a decrease, in past due receivables unveils a weakcollection policy.

c. Incorrect. A poor technique is where the same supplier delivers to different sitesbased on different terms suggesting the company is not leveraging its collective volumeto maximize terms and prices.

d. Correct. A symptom that exists in companies with poor working capitalmanagement techniques is that vendors have imposed credit restrictions orsanctions on the company due to past due payments and concern that thecompany may be a credit risk.

9. a. Incorrect. Efficient trade receivable, not trade payables, collection procedurescan minimize bad debts.

b. Incorrect. Efficient inventory management can reduce the amount of obsolescence,not increase it.

c. Incorrect. Excess cash from efficient cash flow management can be used to paydown debt and, in turn, minimize interest expense, not establish more accounts.

d. Correct. If an entity has efficient working capital management, that entity canuse excess cash generated from trade receivable and inventory management tomaximize purchase discounts.

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¶10,105 MODULE 2—CHAPTER 51. a. Incorrect. Consolidation occurs if there is more than 50 percent of the votingshares in another entity.

b. Incorrect. The cost method applies if one entity owns less than 20 percent of thevoting shares in another entity and the investment is a non-security.

c. Incorrect. The fair value method may be applied if one entity owns less than 20percent of the voting shares in another entity and the investment is a security. Fairvalue does not apply if ownership of voting equity exceeds 50 percent.

d. Correct. If one entity owns between 20-50 percent of the voting shares orwhere one entity has significant influence over another, the accounting treatmentfor the investment generally is to use the equity method. Significant influence isassumed at between 20 percent and 50 percent ownership.

2. a. Incorrect. With respect to an entity that manages, but does not own, anotherentity, consolidation is unlikely unless that entity has a controlling financial interest inthe other entity.

b. Correct. The general rule for consolidation of entities found in ASC 810 is thatconsolidation occurs when one entity directly or indirectly has a controllingfinancial interest in another entity.

c. Incorrect. Although consolidation can occur at less than 50 percent ownershipthrough one of the consolidation exceptions, the general rule does not state thatconsolidation occurs at less than 50 percent ownership.

d. Incorrect. Under the VIE rules, consolidation can occur with respect to an off-balance-sheet entity but that entity must first be a VIE.

3. a. Incorrect. The cost method does not apply to the GP’s investment in situations inwhich the GP controls the LP.

b. Incorrect. When a GP controls an LP, recording the fair value is not appropriate.

c. Incorrect. The equity method is not appropriate when a GP controls an LP.

d. Correct. Existing GAAP provides that when a GP controls an LP, the GPshould consolidate the LP, regardless of ownership percentage.

4. a. Incorrect. An entity that owns less than 20 percent of another entity’s votingstock records the investment at cost or fair value. Because there is no commonownership, it is unlikely that combining financial statements would be meaningful.

b. Incorrect. An entity that owns more than 50 percent of another entity’s voting stockis required to consolidate and does not have the option to combine financial statements.

c. Incorrect. An off-balance-sheet entity that is a VIE and meets certain criteria toconsolidate under FIN 46R is required to consolidate. Therefore, combining financialstatements is not an option.

d. Correct. Two entities with common ownership that do not meet the criteria forconsolidation may elect to issue combined financial statements even thoughsuch combining is never required. The issue is whether combining ismeaningful.

5. a. Incorrect. An entity is considered a VIE if, by design it has at least one of twoconditions. One of those conditions is that the total equity investment at risk is notsufficient to permit it to finance its activities without obtaining additional subordinated

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financial support provided by any parties. The other condition is that it lacks threecharacteristics. One of the three characteristics is that they lack the obligation to absorbthe expected losses of the entity.

b. Incorrect. An entity is considered a VIE if it has at least one of two conditions. Onecondition is that it lacks three characteristics. One of the three characteristics is that theholders lack the right (not have the right) to receive expected residual returns of theentity.

c. Correct. One of the three characteristics is that as a group, the holders ofequity investments at risk lack the power to direct the entity’s activities.

d. Incorrect. An entity is considered a VIE if it has at least one of two conditions. Onecondition is that it lacks three characteristics. Creating the entity at inception is not oneof the three characteristics under the VIE model.

6. a. Correct. ASU 2015-02 states that fees paid to a reporting entity areexcluded from the primary beneficiary test if two conditions are met. One is thatthe fees are compensation for services. The other is that the service arrangementterms, conditions or amounts that are customarily present in similararrangements.

b. Incorrect. The fees are excluded in certain cases in which specific conditions aremet.

c. Incorrect. The ASU states that the exclusion rule does not reflect fees that are partof arrangements that exposes the entity to risk of loss.

d. Incorrect. Fees paid to a reporting entity include those fees paid to both a decisionmaker and a service provider.

7. a. Incorrect. Non-substantive participating rights do not overcome the presumptionbecause they do not allow the LP to participate in certain partnership actions.

b. Incorrect. Protective rights only block certain actions and do not impact whether anLP consolidates a limited partnership.

c. Correct. Substantive participating rights overcome the presumption that thelimited partner that holds the majority of the kick-out rights shall consolidate theLP. Substantive participating rights allow the non-controlling limited partner toeffectively participate in certain partnership actions.

d. Incorrect. Protective rights only block certain actions and do not impact whether alimited partner consolidates an LP even if they are substantive.

8. a. Incorrect. One of the barriers is that the limited partners have the inability (notability) to obtain the information necessary to exercise the rights. Another barrier isfinancial penalties or operational barriers associated with dissolving the limited partner-ship or replacing the general partners that would act as a significant disincentive fordissolution or removal.

b. Incorrect. The absence (not existence) of an adequate number of qualified replace-ment general partners or the lack of adequate compensation to attract a qualifiedreplacement is a barrier.

c. Correct. ASU 2015-02 states that one barrier that could make kick-out rightsless substantive is if the rights are subject to conditions that make it unlikelythey will be exercisable. One example given is if there are conditions thatnarrowly limit the timing of the exercise.

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d. Incorrect. One barrier is the absence (not existence) of an explicit, reasonablemechanism in the limited partnership’s governing documents or in the applicable lawsor regulations, by which the limited partners holding the rights can conduct a vote toexercise the rights.

9. a. Incorrect. Typically acquisitions of assets undertaken not in the ordinary courseof business are considered protective rights while those undertaken in the ordinarycourse of business are participating rights.

b. Incorrect. Dispositions of assets undertaken not in the ordinary course of businessare protective rights, not those in the ordinary course of business.

c. Correct. ASU 2015-02 identifies amendments to articles of incorporation orthe partnership agreement of an investee as typically being considered protectiverights.

d. Incorrect. Selecting and setting compensation of management is typically a partici-pating right.

10. a. Incorrect. ASU 2015-02 changes existing GAAP by eliminating three of the sixconditions for evaluating whether a fee paid to a decision maker or a service providerrepresents a variable interest.

b. Incorrect. The amendments in the ASU 2015-02 specify that some fees paid to adecision maker or service provider are excluded from the evaluation of the economicscriterion (second criterion) if the fees are both customary and commensurate with thelevel of effort required for the services provided. The ASU amendments make it lesslikely for a decision maker or service provider to meet the economics criterion solely onthe basis of a fee arrangement.

c. Correct. ASU 2015-02 does not make amendments with respect to thedetermination of a primary beneficiary. Based on current GAAP, a VIE is consol-idated by a primary beneficiary entity if that entity has a controlling financialinterest in the VIE through having both the power to direct the activities thatmost significantly impact the VIE’s economic performance, and the obligation toabsorb losses of the VIE that could potentially be significant to the VIE or theright to receive benefits from the VIE that could potentially be significant to theVIE.

d. Incorrect. The amendments in ASU 2015-02 reduce the application of the relatedparty guidance for VIEs on the basis of three changes.

11. a. Correct. Participating rights are those rights that provide an entity theability to block or participate in the actions through which an entity exercises thepower to direct the activities of VIE that most significantly impact the VIE’seconomic performance. Participating rights do not require the holders of suchrights to have the ability to initiate actions.

b. Incorrect. Kick-out rights represent the ability to remove the entity with the powerto direct the activities of a VIE that most significantly impact the VIE’s economicperformance or to dissolve/liquidate the VIE without cause.

c. Incorrect. Protective rights are the rights designed to protect the interest of theparty holding those rights without giving that party a controlling financial interest in theentity to which they relate. For example, these include approval or veto rights grantedto other parties that do not affect the activities that most significantly impact the entity’seconomic performance.

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d. Incorrect. Withdrawal rights are the limited partners’ unilateral rights to withdrawfrom the partnership in whole or in part that does not require dissolution or liquidationof the entire limited partnership would not be deemed a kick-out right. The requirementto dissolve or liquidate the entire limited partnership upon the withdrawal of a limitedpartner shall not be required to be contractual for a withdrawal right to be considered asa potential kick-out right.

12. a. Incorrect. One of the conditions that was eliminated by ASU 2015-02 is thatsubstantially all of the fees are at or above the same level of seniority as other operatingliabilities of the entity that arise in the normal course of the entity’s activities, such astrade payables.

b. Incorrect. ASU 2015-02 eliminated three conditions, one of which is the total amountof anticipated fees are insignificant relative to the total amount of the VIE’s anticipatedeconomic performance.

c. Correct. One of the three conditions is that the fees are compensation forservices provided and are commensurate with the level of effort required toprovide those services (e.g., the fees are at an arms-length rate).

d. Incorrect. One of three conditions eliminated by ASU 2015-02 is that the anticipatedfees are expected to absorb an insignificant amount of the variability associated with theentity’s anticipated economic performance.


1. a. Incorrect. In general, a loss from a terrorist attack would not be anextraordinary item because the infrequency of occurrence and unusual in naturecriteria are not met. The reason is because it is reasonable that such an attackcould occur again in the foreseeable future. Moreover, starting in 2016, ASU2015-01 removed the concept of extraordinary items altogether from GAAP.

b. Incorrect. There is no authority for presenting such a transaction as part of incomefrom discontinued operations because it has nothing to do with the elimination of aparticular operation of an entity.

c. Correct. Because the criteria for extraordinary treatment (which was elimi-nated in 2016 with the issuance of ASU 2015-01) are not satisfied, the lossshould be presented as part of income from continuing operations.

d. Incorrect. The loss should be presented on the income statement and not part ofretained earnings because there is no authority to present it initially in retainedearnings.

2. a. Incorrect. GAAP does not permit that a gain contingency be recorded.

b. Correct. A receivable related to the insurance recovery should be recordedonly when realization of the claim is deemed probable. Also, a gain should not berecognized until any related contingencies have been resolved.

c. Incorrect. It should be recorded when realization is probable which is well beforethe cash from the insurance claim is received.

d. Incorrect. Using a best estimate would be tantamount to recording a gain contin-gency. Recording a receivable related to a gain contingency is not permitted underGAAP.

3. a. Incorrect. There is one specific restriction.

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b. Incorrect. The size of the insurance recovery is not an issue in determining itsclassification.

c. Correct. An entity may choose how it wants to classify business interruptioninsurance recoveries in the statement of operations as long as the classificationis not contrary to existing GAAP.

d. Incorrect. There is no requirement that the amount be characterized as unusual orextraordinary.


1. a. Correct. Prior to the FASB issuing ASU 2014-15, the going concernassessment was found only in auditing literature in AU-C 570, and not GAAP.

b. Incorrect. Prior to the issuance of ASU 2014-15, there was no requirement formanagement to assess going concern.

c. Incorrect. There has never been a requirement for the board of directors to assessgoing concern.

d. Incorrect. Auditing standards have required that an auditor perform a going-concern assessment.

2. a. Incorrect. The transaction should be accounted for as internal-use software onlyif it includes a software license, which it does not.

b. Correct. If a cloud computing arrangement does not include a softwarelicense, the customer should account for the arrangement as a service contract.

c. Incorrect. At best, the asset is an intangible asset, and not a prepaid one, as there isno evidence to suggest there is a prepaid expense that should be recorded.

d. Incorrect. GAAP does not provide for expensing a portion while capitalizing theremainder.

3. a. Incorrect. Debt issuance costs are capitalized and amortized, and not expensed asincurred.

b. Incorrect. The previous rules required the debt issuance costs to be recorded as anasset and amortized. Under ASU 2015-03, recording those costs as an asset is no longeran option.

c. Correct. The ASU requires that the debt issuance costs be presented as a netamount against the underlying debt.

d. Incorrect. The ASU does not permit the costs to be presented as a contra- equityaccount as they have nothing to do with equity.

¶10,108 MODULE 3—CHAPTER 81. a. Incorrect. With a defined contribution or 401(k) plan, not a defined benefit plan, acompany can more accurately measure the amount of its pension cost because it isbased on the amount contributed to the plan, and not based on a defined paymentamount.

b. Incorrect. A sponsor of a defined benefit plan has fixed, measured contributionsrequired with no discretion to those payments. To the contrary, most defined contribu-tion or 401(k) plans allow a company to structure its contributions to be discretionary,thereby allowing it to reduce its pension contribution during weaker business cyclesand increase it during stronger cycles.

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c. Incorrect. Investment risk remains with a company that sponsors a defined benefitplan. Alternatively, with 401(k) plans, investment risk shifts from the company to theemployee as each employee is responsible for managing his or her investments.

d. Correct. With defined benefit pension plans, the amount of its pension cost isbased on the amount of the ultimate benefit paid, discounted back to the currentyear.

2. a. Incorrect. ASC 715 does not apply to defined contribution pension plans but doesapply to defined benefit plans.

b. Incorrect. The FASB statement requires a company to record the funded status ofthe plan on the balance sheet. It does not require that a portion of the plan liability berecorded.

c. Correct. The Statement introduces greater transparency of plan disclosures onthe sponsor’s balance sheet by including the entire funded status on the balancesheet.

d. Incorrect. ASC 715 does not relate to postretirement health benefits. ASC 715addresses the accounting for retirement plans only.

3. a. Incorrect. Multi-employer plans are underfunded by about $428 billion.

b. Incorrect. Multi-employer plans are significantly underfunded by far greater than 10percent.

c. Correct. According to Credit Suisse, multi-employer plans are grossly un-derfunded at as much as 46 percent, which places them in a critical fundedstatus zone.

d. Incorrect. Multi-employer plans have been underfunded for several years andcontinue to be underfunded. There is no evidence that changes in actuarial assumptionscontributed to the underfunded status.

4. a. Incorrect. Yellow is between 65 percent and 80 percent funded status. In thisfunding zone, a funding improvement plan is required.

b. Correct. Green zone occurs at a funded status of more than 80 percent.

c. Incorrect. Orange, like yellow, occurs between 65 percent and 80 percent fundedstatus. However, orange is considered a seriously endangered level and the plan has anaccumulated funding deficiency or is expected to have one during any of the next sixyears. Like the yellow status, plans in this zone are required to have a fundingimprovement plan.

d. Incorrect. Red occurs at less than 65 percent funded status which is far less than 86percent. The red zone is considered a critical zone and a rehabilitation plan is required.

5. a. Correct. Use of a higher discount rate results in a lower pension liabilitybeing calculated. As the discount rate increases, the present value of the pensionliability is decreased. The general rule is that for every one percent increase inthe discount rate, the pension liability drops by about 15 percent.

b. Incorrect. Using a lower, not higher, compensation growth rate results in a lowerpension liability because future benefits estimated to be paid will be lower.

c. Incorrect. The actual rate of return does not affect the pension liability calculation.

d. Incorrect. Use of a higher, not lower, expected rate of return results in the periodicpension cost being lower. A lower periodic pension cost results in a lower pensionliability accrual.

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6. a. Incorrect. The rate of a Treasury instrument is synonymous with a risk-free rateof return. GAAP does not provide for using the risk-free rate of return for measuring thepension obligation.

b. Correct. The rate used is that of a high-quality fixed-income investment whichincludes either an AA or AAA-rated corporate bond.

c. Incorrect. The rate should be that of a high-quality corporate investment, whichdoes not include the rate of a junk bond.

d. Incorrect. An overnight repo is not a high-quality fixed-income investment. It is ashort-term investment which does not match the term of the pension liability.

7. a. Incorrect. The results of the AICPA study show that 30 percent believe thepressures to compete in the marketplace outweigh the pressures to provide retirementbenefits.

b. Incorrect. The results of the AICPA study show that 54 percent suggested that theerosion of benefits would hurt recruiting and retention efforts.

c. Incorrect. The results of the AICPA study show that 65 percent of respondents offer401(k) plans with matching contributions.

d. Correct. The results of the AICPA study show that 74 percent of respondentsstated that U.S. companies cannot continue providing employees with pensionsthat adequately cover their retirement years. Fifty-seven percent believe risinghealthcare costs are the biggest obstacle to a company’s ability to offer pensionbenefits.

8. a. Incorrect. Because the mortality life of both males and females have increased byabout two years, pension contribution requirements will be higher to accommodate thelonger lives of plan participants.

b. Correct. Because pension liabilities will be higher, the funded status (assetsas a percent of liabilities) will be lower.

c. Incorrect. Because the liability will be higher due to longer actuarial lives, there willbe high lump-sum payout requirements.

d. Incorrect. Higher liabilities will require higher, not lower, PBGC variable ratepremiums because those premiums are based on liability amounts.

9. a. Correct. Recently, companies are beginning to shift their investments tomore bonds instead of equity holdings. With bonds, companies can more closelymatch returns with future pension commitments and bonds offer less risk fromvolatility of the stock market.

b. Incorrect. Companies are reducing their investments in equities given the increas-ing risk of volatility of the stock market. This volatility makes it difficult for sponsors tomore closely match returns with future pension commitments.

c. Incorrect. As mutual funds are generally a mix of certain equity investments, theseequity instruments are continuing to be reduced in the portfolio of pension plan assets.This is due in part to the increasing volatility of the stock market and difficulty inmatching returns to future pension commitments.

d. Incorrect. An index fund is a type of mutual fund with a portfolio constructed tomatch or track the components of a certain market index, such as the S&P 500. Whilean index fund provides broad market exposure, the volatility of the stock market makesthis a difficult investment for a pension plan sponsor to use when attempting to matchreturns with future pension commitments.

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189

IndexReferences are to paragraph (¶ ) numbers.

ASC 810, Consolidation of Variable Interest Entities . . . 106,A112, 501

. ASU 2015-02 changes to . . . . . . . . . . . . . 506, 509, 514Accounting principles, proposed changes in . . . . . . . 604

. based on ownership percentage . . . . . . . . . . . . . . 504Accounting Standards Updates (ASUs) . . . . . . . . . . 404

. FIN 46R now part of . . . . . . . . . . . . . . . . . . . . . 505Accounts payable, inefficient management of . . . . . . 407 . subsidiaries’ consolidation requirement of . . . . . . . . . 505

Accounts receivable as gain contingency . . . . . . . . . 604 ASC 840, Leases . . . . . . . . . . . . . . . . . . . . . . 104–112

Accounts receivable balances . . . . . . . . . . . . . 406, 407 ASC 850, relationships of partners under . . . . . . . . . 510

Accumulated earnings tax (AET) . . . . . . . . . . . . . . 112 ASC 852, liquidation of investee under . . . . . . . . . . . 510

Acts of God . . . . . . . . . . . . . . . . . . . . . . . . . 601–608 ASC 855, information available after balance sheet. Code Sec. 1033 special involuntary conversion rule date under . . . . . . . . . . . . . . . . . . . . . . . . . . 812

for . . . . . . . . . . . . . . . . . . . . . . . . . . . . 607ASC 960, presentation of pension plan obligations

. disclosure requirements for . . . . . . . . . . . . . . . . . 604 under . . . . . . . . . . . . . . . . . . . . . . . . . . . . 812

. losses from terrorism and . . . . . . . . . . . . . . . . . . 605ASC 985, Software-Revenue Recognition . . . . . . . . . 705. potential risk of, vulnerability to . . . . . . . . . . . . . . . 604

. recent U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . 603 ASU 2009-06, Income Taxes: ImplementationGuidance on Accounting for Uncertainty in Income Taxes. U.S. GAAP accounting for . . . . . . . . . . . . . . . 601–608and Disclosure Amendments for Nonpublic Entities (ASC

AIMR, Global Corporate Financial Reporting Quality740), FIN 48 amended by . . . . . . . . . . . . . . . . . 306

by . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404ASU 2010-10, Consolidation (Topic 810):

Airlines, retirement plans of . . . . . . . . . . . . . . . . . 803 Amendments for Certain Investment Funds . . . . . . 514Annual reports of public companies . . . . . . . . . . . . 404 ASU 2014-07, Consolidation (Topic 810): Applying

Variable Interest Entities Guidance to Common ControlASC 210, closely held investments under . . . . . . . . . 504Leasing Arrangements—A Consensus of the Private

ASC 225, Income Statement—Business InterruptionCompany Council . . . . . . . . . . . . . . . . . . . . . 505

Insurance . . . . . . . . . . . . . . . . . . . . . . . . 604, 608ASU 2014-15, Presentation of Financial

ASC 230, Statement of Cash Flows . . . . . . . . . . . . . 406Statements—Going Concern (Subtopic 205-40):Disclosure of Uncertainties About an Entity’s Ability toASC 275, Risks and Uncertainties . . . . . . . . . . . . . 604Continue as a Going Concern . . . . . . . . . . . . . . 704

ASC 320, recording securities under . . . . . . . . . . . . 504ASU 2014-18, Business Combinations (Topic 805):

ASC 323, equity method use under . . . . . . . . . . . . . 504Accounting for Identifiable Intangible Assets in a

ASC 330, Inventory . . . . . . . . . . . . . . . . . . . . 203, 205 Business Combination (A Consensus of the Private. disclosure requirements of . . . . . . . . . . . . . . . . . 206 Company Council) . . . . . . . . . . . . . . . . . . . . . 707

ASU 2015-01, Income Statement—Extraordinary andASC 350, Intangibles—Goodwill andUnusual Items (Subtopic 225-20: Simplifying IncomeOther—Internal-Use Software . . . . . . . . . . . . . . 705Statement Presentation by Eliminating the Concept of

ASC 360, Impairments . . . . . . . . . . . . . . . . . . . . 607Extraordinary Items) . . . . . . . . . . . . . . . . . . . . 605

ASC 410, Asset Retirement and EnvironmentalASU 2015-02, Consolidation (Topic 810): Amendments to the

Obligations . . . . . . . . . . . . . . . . . . . . . . . . . 608Consolidation Analysis

ASC 450, Contingencies . . . . . . . . . . . . . . . . . . . 510 . amendments to consolidations guidance for publicentities by . . . . . . . . . . . . . . . . . . . 501, 506, 509ASC 605

. changes to ASC 810 guidance by . . . . . . . . 506, 509, 514. insurance recoveries under . . . . . . . . . . . . . . . . . 608

. consolidation of limited partnerships changes by . . . . . 510. involuntary conversions under . . . . . . . . . . . . . . . 604

. definitions in amendments of . . . . . . . . . . . . . . . . 507ASC 715, Retirement Benefits Compensation . . 804, 805, 807 . effective date of . . . . . . . . . . . . . . . . . . . . . 503, 515

. exemption for money market funds consolidationASC 740, Income Taxesunder . . . . . . . . . . . . . . . . . . . . . . . . . 506, 514. amendment by ASU 2015-17 of . . . . . . . . . . . . . . 305

. fees paid to decision makers or service providers. average graduated tax rate used under . . . . . . . . . . 306under . . . . . . . . . . . . . . . . . . . . . . . . . 506, 511. balance sheet presentation of deferred tax liabilities

. issuance of . . . . . . . . . . . . . . . . . . . . . . . . 503, 506and assets under . . . . . . . . . . . . . . . . . . . . 305

. key changes made by . . . . . . . . . . . . . . . . . . . . 509. cumulative losses under . . . . . . . . . . . . . . . . . . 306

. objective of . . . . . . . . . . . . . . . . . . . . . . . . 503, 506. effects of change in tax laws or rates under . . . . . . . . 303

. related parties in VIE consolidation under . . . . . . . . . 513. as GAAP authority for accounting for income taxes . . . . 303

. transitions to . . . . . . . . . . . . . . . . . . . . . . . . . 515. more likely than not standard for tax positions under . . . 306

. variable interest entities under . . . . . . . 504, 505, 506, 511. NOL carryforwards and carrybacks under . . . . . . . 304, 306. recognition of valuation account under . . . . . . . . . . . 304 ASU 2015-03, Interest—Imputation of Interest. recording deferred tax liability or assets under, . . . . . . 306 (Subtopic 835-20): Simplifying the Presentation of Debt. uncertain tax positions under . . . . . . . . . . . . . . . . 306 Issuance Costs . . . . . . . . . . . . . . . . . . . . . . . 706

ASU

190 TOP ACCOUNTING ISSUES FOR 2017 CPE COURSE - INDEX

ASU 2015-05, Intangibles—Goodwill and Centre for Financial Market Integrity CFA Institute, AOther—Internal-Use Software (Subtopic 350-40): Comprehensive Business Reporting Model, FinancialCustomer’s Accounting for Fees Paid in a Cloud Reporting for Investors by . . . . . . . . . . . . . . . . 404Computing Arrangement . . . . . . . . . . . . . . . . . 705 CFO.com, Compensation and Cash Flow by . . . . . . . 407

ASU 2015-11, Inventory (Topic 330)-Simplifying the Charitable contributions, carryforwards of . . . . . . . . 306Measurement of Inventory

Cloud computing arrangement, fees in . . . . . . . . . . 705. challenge for manufacturers in applying . . . . . . . . . . 205. changes resulting from . . . . . . . . . . . . . . . . . . . 204 Code Sec. 1.471-4, Inventories at Cost or Market . . . . . 205. disclosure requirements of . . . . . . . . . . . . . . . . . 206

Collection efforts, measurement benchmarks for . . . . 406. implementation of . . . . . . . . . . . . . . . . . . . . . . 207

Collective bargaining agreements for pension plans,. IRS Code Sec. 1.471-4 versus . . . . . . . . . . . . . . . 205union . . . . . . . . . . . . . . . . . . . . . . . . . . . 803, 806. issuance of . . . . . . . . . . . . . . . . . . . . . . . . 201, 203

. objectives of . . . . . . . . . . . . . . . . . . . . . . . . . 205 Combined financial statements . . . . . . . . . . . . . . . 504

. restoration of write-downs under . . . . . . . . . . . . . . 205 . for variable interest entities . . . . . . . . . . . . . . . . . 505

ASU 2015-17, Income Taxes (Topic 740: Balance CompensationSheet Classification of Deferred Taxes . . . . . . . . . 305 . employee, trends in . . . . . . . . . . . . . . . . . . . . . 811

. executive . . . . . . . . . . . . . . . . . . . . . . . . . . . 407ASU 2016-01, Financial Instruments—Overall(Subtopic 825-10): Recognition and Measurement of Concentration of risk of loss . . . . . . . . . . . . . . . . 604Financial Assets and Financial Liabilities . . . . . . . 504

Consolidation analysis . . . . . . . . . . . . . . . . . . 501–515ASU 2016-02, Leases . . . . . . . . . . . . . . . . . . . 107, 108 . models used in . . . . . . . . . . . . . . . . . . . . . . . . 508. effective date for and transition to . . . . . . . . . . . . . 111

Consolidation of financial statements, GAAP rulesASUs issued in 2014 to 2016, table of . . . . . . . . . . . 703 for . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504, 505

. ASU-205-02 changes to . . . . . . . 506, 511, 512, 513, 514AU-C Section 500, Audit Evidence . . . . . . . . . . . . . 812

Contractual management agreement, consolidationAU-C Section 560, Subsequent Events andunder . . . . . . . . . . . . . . . . . . . . . . . 504, 505, 508Subsequently Discovered Facts . . . . . . . . . . . . . 812

Controlling financial interestAU-C Section 570, The Auditor’s Consideration of an. conditions by entity type for . . . . . . . . . . . . . . . . . 508Entity’s Ability to Continue as a Going Concern . . . 704. for consolidation . . . . . . . . . . . . . . . . . . . . . 506, 510

Auditing Standards Board interpretation of going-Core earnings formula . . . . . . . . . . . . . . . . . . . . 407concern rules . . . . . . . . . . . . . . . . . . . . . . . . 704

Corporate income tax rate . . . . . . . . . . . . . . . . . . 303Auditor. proposals to reduce . . . . . . . . . . . . . . . . . . . . . 306. going concern assessment by . . . . . . . . . . . . . . . 704

. management’s specialist evaluated by . . . . . . . . . . . 812 Credit-collection efficiency . . . . . . . . . . . . . . . . . 406Audits, tax, use of GAAP information in . . . . . . . . . . 306 Credit Suisse, Crawling Out of the Shadows by . . . . . 806

Cumulative losses . . . . . . . . . . . . . . . . . . . . . . . 306B

DBalance sheet. debt issuance costs of . . . . . . . . . . . . . . . . . . . . 706

Debt issuance costs . . . . . . . . . . . . . . . . . . . . . 706. deferred tax liabilities and assets on . . . . . . . . . . 303, 305. focus on statement of income versus . . . . . . . . . . . 407 Debt to finance capital expenditures . . . . . . . . . . . . 406. inclusion of off-balance-sheet transactions on . . . . . . 404

Decision maker. lease assets and obligations on . . . . . . . . . . . . . . 112

. definition of . . . . . . . . . . . . . . . . . . . . . . . . . . 507. pension costs and funding status on . . . . . . . . . . 804, 805

. fees paid to VIE . . . . . . . . . . . . . . . . . . 506, 511, 512Bankruptcy code used to shed pension obligations . 806, 810 . related-party relationships of . . . . . . . . . . . . . . . . 513

Bond ratings and returns . . . . . . . . . . . . . . . . . 807, 813 Decision-making authority. definition of . . . . . . . . . . . . . . . . . . . . . . . . . . 507Boston 2013 terrorist attack . . . . . . . . . . . . . . . 603, 606. of PPME . . . . . . . . . . . . . . . . . . . . . . . . . . . 505

Business combination, accounting for . . . . . . . . . . . 708Deconsolidation of legal entity . . . . . . . . . . . . . . . 515

Business reporting model . . . . . . . . . . . . . . . . . . 401Deferred income taxes . . . . . . . . . . . . . . . . . . . . 301. recommended principles for . . . . . . . . . . . . . . . . 404. benefit of NOL carryforward on . . . . . . . . . . . . . . . 304. effects of tax reform on . . . . . . . . . . . . . . . . . . . 303C. recorded for insurance proceeds . . . . . . . . . . . . . . 608

Capital assets, noncash purchases of . . . . . . . . . . . 406 Deferred tax liabilities and assets. balance sheet classification of . . . . . . . . . . . . . . . 305Capital expenditures, debt for . . . . . . . . . . . . . . . . 406. disclosure of . . . . . . . . . . . . . . . . . . . . . . . . . 306

Capital losses, carryforwards of . . . . . . . . . . . . . . 306 . recording . . . . . . . . . . . . . . . . . . . . . . . . . . . 306Carrying amounts, definition of . . . . . . . . . . . . . . . 515 Defined benefit plans.See Pension plansCash flow, focus on free . . . . . . . . . . . . . . . . . . . 406 Defined contribution plans . . . . . . . . . . . . . . . . . . 803Cash flow management, efficient . . . . . . . . . . . . . . 407 Disclosure framework project (FASB) . . . . . . . . . . . 306Cash flow statement.See Statement of cash flows DisclosuresCatastrophe, definition of . . . . . . . . . . . . . . . . . . . . . . for cash flows arising from leases . . . . . . . . . . . . . 110

. . . . . . . . . . . . . . 604.See also Acts of God; Terrorism . for debt issuance costs . . . . . . . . . . . . . . . . . . . 706

ASU

http://CFO.com

191TOP ACCOUNTING ISSUES FOR 2017 CPE COURSE - INDEX

Disclosures—continued FIN 48 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306. duplicate . . . . . . . . . . . . . . . . . . . . . . . . . . . 404 . amendment by ASU 2009-06 of . . . . . . . . . . . . . . 306. FIN 48 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306 Financial Accounting Standards Board (FASB).See also. financial community’s view of . . . . . . . . . . . . . . . . 404 FASB-IASB joint standards projects; GAAP (generally. in footnotes . . . . . . . . . . . . . . . . . . . . . . . . 404, 706 accepted accounting procedures), U.S.. for nonpublic companies and not-for-profit . accounting pronouncements responding to . . . . . . . . 404

organizations . . . . . . . . . . . . . . . . . . . . 306, 404 . disclosure framework project of . . . . . . . . . . . . . . 306. omission or removal of . . . . . . . . . . . . . . . . . . . 404 . disclosure requirements of . . . . . . . . . . . . . . . . . 404. for open tax years . . . . . . . . . . . . . . . . . . . . . . 306 . Financial Performance Reporting Project of . . . . . . 405, 407. overload of . . . . . . . . . . . . . . . . . . . . . . . . . . 404 . negative evidence for . . . . . . . . . . . . . . . . . . . . 306. for pension plans and postretirement benefits . . . . . 404, 807 . Simplification Initiative of . . . . . . . 201–205, 305, 705, 706. quality of . . . . . . . . . . . . . . . . . . . . . . . . . . . 404 . stock option expensing requirement of . . . . . . . . . . . 407. for risk factors . . . . . . . . . . . . . . . . . . . . . . . . 404

Financial covenants under new lease standard . . . . . . 112. for risks and uncertainties . . . . . . . . . . . . . . . . 603, 604. for temporary differences . . . . . . . . . . . . . . . . . . 306 Financial performance reporting . . . . . . . . . . . . 401–407. for terrorism versus acts of God . . . . . . . . . . . . . . 603 . complexity of, complaints with . . . . . . . . . . . . . . . 404. for uncertain tax positions . . . . . . . . . . . . . . . . . . 306 . demands for transparency in . . . . . . . . . . . . . . 401, 403. for undistributed foreign earnings . . . . . . . . . . . . . 306 . FASB project for . . . . . . . . . . . . . . . . . . . . . . . 405

. financial community’s view of . . . . . . . . . . . . . . . . 404Discount rate for pensions

. focus of . . . . . . . . . . . . . . . . . . . . . . . . . . . . 406. decline in . . . . . . . . . . . . . . . . . . . . . . . . . . . 813

. neutrality needed in . . . . . . . . . . . . . . . . . . . . . 404. definition of . . . . . . . . . . . . . . . . . . . . . . . . . . 807

. quality survey of . . . . . . . . . . . . . . . . . . . . . . . 404. for public pension plans under GASB 68 . . . . . . . . . 808. risk-free . . . . . . . . . . . . . . . . . . . . . . . . . . . 807 Financial Reporting Releases . . . . . . . . . . . . . . . . 404

Financial standards, principles-based . . . . . . . . . . . 404E

Financial statements.See also individual types. combined . . . . . . . . . . . . . . . . . . . . . . . . . 504, 505Earnings before interest, taxes, depreciation, and. consolidation for . . . . . . . . . . . . . . . . . . . . . 504, 505amortization (EBITDA) . . . . . . . . . . . . . . . . . . 112. deferred tax asset or liability on . . . . . . . . . . . . . 303, 305

Earnings per share (EPS), operating and core . . . . . . 407. disclosures in, XBRL tagging for . . . . . . . . . . . . . . 404

EDGAR database of required public filings . . . . . . . . 306 . FASB-IASB initiatives for presentation of . . . . . . . . . 405. footnote disclosures in . . . . . . . . . . . . . . . . . 404, 706Emerging Issues Task Force (EITF) consensuses . . . . 404. impact of lease accounting changes to . . . . . . . . . . 112. on losses from terrorist attacks and acts of God . . . . . 605. income tax basis for . . . . . . . . . . . . . . . . . . . . . 112

Employee benefit plan, financial statements of . . . . . . 111 . NOL carryovers on . . . . . . . . . . . . . . . . . . . . . 306Employment statistical trends . . . . . . . . . . . . . . . . 811 . notes to . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306

. preparers of, comments of . . . . . . . . . . . . . . . . . 404Enron fraud . . . . . . . . . . . . . . . . . . . . . . . . . 401, 403

. recommended principles for . . . . . . . . . . . . . . . . 404Equity markets, volatility of . . . . . . . . . . . . 803, 805, 813 . satisfaction level of users of . . . . . . . . . . . . . . 403, 404

. unrecognized tax benefit liabilities for . . . . . . . . . . . 306Equity method for treatment of voting shares . . . . . . 504

First-in first-out (FIFO) average cost inventoryExecutive compensation, factors in . . . . . . . . . . . . 407method . . . . . . . . . . . . . . . . . . . . . . 201, 204, 205

Expected rate of return . . . . . . . . . . . . . . . . . . 807, 808. losses from . . . . . . . . . . . . . . . . . . . . . . . . . . 206. manufacturers’ use of . . . . . . . . . . . . . . . . . . . . 205

FForm 1120, 1120-L, or 1120-PC Schedule UTP,

Uncertain Tax Position Statement . . . . . . . . . . . . 306Fair value hedge . . . . . . . . . . . . . . . . . . . . . . . . 205

401(k) plansFair value information . . . . . . . . . . . . . . . . . . . . 404. AICPA survey of . . . . . . . . . . . . . . . . . . . . . . . 809

Fair value option for financial instruments . . . . . . . . 515. asset statistics for . . . . . . . . . . . . . . . . . . . . . . 811

FAS 167, Amendments to FASB Interpretation No. . benefits of . . . . . . . . . . . . . . . . . . . . . . . . . . 80346(R), indefinite deferral of . . . . . . . . . . . . . . 506, 514 . discretionary employer contributions to . . . . . . . . . . 803

. as replacing defined benefit plans . . . . . . . . . . . 803, 811FASB Accounting Standards Codification . . . . . . . . . 707

Free cash flow . . . . . . . . . . . . . . . . . . . . . . . . . 406FASB-IASB joint standards projects.See also AccountingStandards Update 2015-11 Future taxable income . . . . . . . . . . . . . . . . . . 304, 306

. financial instruments . . . . . . . . . . . . . . . . . . . . 404

. lease accounting rule . . . . . . . . . . . . . . . . . . 106, 404 G

. revenue recognition . . . . . . . . . . . . . . . . . . . . . 404

GAAP exception . . . . . . . . . . . . . . . . . . . . . . . . 603FASB Simplification Initiative . . . . . . . . . . . 201–205, 305. ASUs recently issued as part of . . . . . . . . . . . . 705, 706 GAAP (generally accepted accounting procedures),. objective of . . . . . . . . . . . . . . . . . . . . . . . . 705, 706 U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601–608

. accrual basis income in . . . . . . . . . . . . . . . . . . . 406Federal Reserve, interest rate actions by . . . . . . . . . 807

. audit report reference to departure from . . . . . . . . . . 306FIN 46, accounting pronouncements responding to . . . 404 . average graduated tax rates for temporaryFIN 46R, Consolidation of Variable Interest differences under . . . . . . . . . . . . . . . . . . . . 306

Entities—An Interpretation of ARB No. 51 . . . . . . . 505 . confusion over measures in . . . . . . . . . . . . . . . . . 406. amendment by SFAS 167 of . . . . . . . . . . . . . . . . 506 . consolidation rules under . . . . . . . . . . . . . 504, 505, 506. deferral of amendments to . . . . . . . . . . . . . . . 506, 514 . for fees paid to decision makers . . . . . . . . . 506, 511, 512

GAA


GAAP (generally accepted accounting procedures), U.S.— Insurance recoveries—continuedcontinued . tax status of . . . . . . . . . . . . . . . . . . . . . . . . . 607

. for going concern assessments . . . . . . . . . . . . . . 704 . from terrorist attacks . . . . . . . . . . . . . . . . . . . . 606

. for income taxes . . . . . . . . . . . . . . . . . . . . . . . 303 Intangible assets, fair value of . . . . . . . . . . . . . . . . 707

. for investments and consolidations . . . . . . . . . . . . . 504Interest, classification disclosures for . . . . . . . . . . . 306. for involuntary conversions . . . . . . . . . . . . . . . . . 607

. for leases . . . . . . . . . . . . . . . . . . . . . . . . . 108, 112 Interest costs of excess receivables . . . . . . . . . . . . 406

. for limited partnerships . . . . . . . . . . . . . . . . . 506, 510Internal control structure, proposed changes in . . . . . 604

. lower of cost and net realizable value for . . . . . . . . . 205International Accounting Standards Board (IASB),. manipulation of income under . . . . . . . . . . . . . . . 407

financial statement presentation initiative of 405.See also. new standards for . . . . . . . . . . . . . . . . . . . . . . 404FASB-IASB joint standards projects. operating earnings per share for . . . . . . . . . . . . . . 407

. for pension (defined benefit) plans . . . . . 803, 804, 807, 812 International Financial Reporting Standards (IFRS),

. reducing cost and complexity of . . . . . . . . . . . . 705, 706 inventory measurement in . . . . . . . . . . . . . . . . 204

. for service contracts . . . . . . . . . . . . . . . . . . . . . 705Inventory. Simplification Initiative for . . . . . . . . . . . . . . . . . . 203. discarding obsolete . . . . . . . . . . . . . . . . . . . . . 406. terrorism, issues in . . . . . . . . . . . . . . . . . . . 601–608. inefficiently managed . . . . . . . . . . . . . . . . . . . . 407. variable interest entities under . . . . 504, 505, 506, 511, 513. selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . 306

Gain contingencies . . . . . . . . . . . . . . . . . . . . . . 603Inventory measurement . . . . . . . . . . . . . . . . . 201–207

GASB 68, Accounting and Financial Reporting for . lower of cost and net realizable value . . . . . . . . . . . 205Pensions . . . . . . . . . . . . . . . . . . . . . . . . . . 808 . lower of cost or market . . . . . . . . . . . . . . . . . 204, 205

. subsequent . . . . . . . . . . . . . . . . . . . . . . . . . 205General partner controlling limited partnership . . . 504, 505. changes under voting interest entity model for . . . . 506, 510 Inventory, write-down of . . . . . . . . . . . . . . . . . 205, 207. consolidation of limited partnership by . . . . . . . . . . . 510

Investment Company Act of 1940 . . . . . . . . . . . . 506, 514. as variable interest holder . . . . . . . . . . . . . . . . . . 511

Investments, GAAP rules for . . . . . . . . . . . . . . . . 504Georgia Tech Financial Analysis Lab. closely held . . . . . . . . . . . . . . . . . . . . . . . . . 504. Effects of Tax Reform on Deferred Taxes, The, by . . . . 303. in securities . . . . . . . . . . . . . . . . . . . . . . . . . 504. Free Cash Flow and Compensation: A Fashionable

Fad or Something More by . . . . . . . . . . . . . . . 406 Involuntary conversions . . . . . . . . . . . . . . . . . 603, 604. Non-cash Investing and Financial Activities and Free . accounts receivable recorded following . . . . . . . . . . 607

Cash Flow by . . . . . . . . . . . . . . . . . . . . . . 406 . Code Sec. 1033 special rule for . . . . . . . . . . . . 607, 608. Understanding Unrecognized Tax Benefits by . . . . . . 306 . GAAP for . . . . . . . . . . . . . . . . . . . . . . . . . 606, 607

. recognition of gain or loss from . . . . . . . . . . . . . . . 606Going concern assessment . . . . . . . . . . . . . . . . . 704

IRS LB&I, FIN 48 Implications LB&I Field Examiners’Going-concern report modification . . . . . . . . . . . . . 704Guide by . . . . . . . . . . . . . . . . . . . . . . . . . . . 306

Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . 305

Gross margin, “lost” . . . . . . . . . . . . . . . . . . . . . 608 K

Key personnel, proposed changes in . . . . . . . . . . . 604H

Kick-out rightsHealth care costs . . . . . . . . . . . . . . . . . . . . . . . 811

. definition of . . . . . . . . . . . . . . . . . . . . . . . . . . 507Hosting arrangements for software . . . . . . . . . . . . . 705 . for limited partnerships, substantive . . . . 505, 508, 510, 511

. for VIEs . . . . . . . . . . . . . . . . . . . . . . . . . . 506, 507Hurricanes as natural disasters . . . . . . . . . . . . . . . 603

KPMG/FEI, Disclosure Overload and Complexity:I Hidden in Plain Sight by . . . . . . . . . . . . . . . . . 404

IASB 17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 LIdentifiable intangible assets in business

Labor supply matching to manufacturing demand . . . . 406combination . . . . . . . . . . . . . . . . . . . . . . . . 707

Last-in first-out (LIFO) retail inventory method . . . . 201, 204Impairment of fixed asset . . . . . . . . . . . . . . . . . . 607. losses from . . . . . . . . . . . . . . . . . . . . . . . . . . 206

Incentive compensation, free cash flow and . . . . . . . 406. lower of cost and net realizable value applied to . . . . . 205

Income statement, NOL carryover on . . . . . . . . . . . 306Lease accounting . . . . . . . . . . . . . . . . . . . . . 101–112

Income tax rate, corporate, effects of tax reform on . . . 303 . abuses in . . . . . . . . . . . . . . . . . . . . . . . . . . . 105. impact of changes to . . . . . . . . . . . . . . . . . . . . 112Individual retirement accounts (IRAs), employee . . . . 811. right-of-use model in . . . . . . . . . . . . . . . . . . . . 107

Insurance . SEC initiative to change . . . . . . . . . . . . . . . . . . . 105. business interruption . . . . . . . . . . . . . . . . . . 603, 608

Lease payments . . . . . . . . . . . . . . . . . . . . . . . . 108. gains and losses from claims to . . . . . . . . . . . . 604, 607. health . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 811 Lease term . . . . . . . . . . . . . . . . . . . . . . . . . 104, 108. title . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 706 . short . . . . . . . . . . . . . . . . . . . . . . . . . . . 109, 112

Insurance recoveries . . . . . . . . . . . . . . . . . . . 603, 604 Lease-versus-buy decision . . . . . . . . . . . . . . . . . 112. accounts receivable recorded for . . . . . . . . . . . . . . 607

Leasehold improvements . . . . . . . . . . . . . . . . . . 108. business interruption . . . . . . . . . . . . . . . . . . . . 608Leases. Code Sec. 1033 special rule for . . . . . . . . . . . . 607, 608

. property . . . . . . . . . . . . . . . . . . . . . . . . . . . 608 . capital . . . . . . . . . . . . . . . . . . . . . . . 104, 105, 406

GAI


Leases—continued Natural disasters—continued. capitalizing . . . . . . . . . . . . . . . . . . . . . . . . . . 112 . recent U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . 603. consolidation for . . . . . . . . . . . . . . . . . . . . . . . 505 . U.S. GAAP accounting for . . . . . . . . . . . . . . . 601–608. disclosures for . . . . . . . . . . . . . . . . . . . . . . . . 110 Near term, ASC 275 definition of . . . . . . . . . . . . . . 604. liabilities of . . . . . . . . . . . . . . . . . . . . . . . . . . 108

Net assets, reporting changes in . . . . . . . . . . . . . . 404. off-balance-sheet . . . . . . . . . . . . . . . . . . . . . . 105. operating . . . . . . . . . . . . . . . . . . . 104, 105, 111, 112 Net operating losses (NOLs) . . . . . . . . . . . . . . . . . 301. recognition of assets and liabilities for . . . . . . . . . . . 107 . carryback of 2 years of . . . . . . . . . . . . . . . . . 303, 304. related party . . . . . . . . . . . . . . . . . . . . . . . . . 112 . carryforward of 20 years of . . . . . . . . . . . . 303, 304, 306. right-of-use assets for . . . . . . . . . . . . . . . . . . 108, 112 . deferred income tax assets from . . . . . . . . . . . . 304, 305. short-term . . . . . . . . . . . . . . . . . . . . . . . . 109, 112 . state laws for . . . . . . . . . . . . . . . . . . . . . . . . . 305. structure of . . . . . . . . . . . . . . . . . . . . . . . . . . 112 . tax-planning strategies for . . . . . . . . . . . . . . . . . 306. Type A and Type B classes of . . . . . . . . . . . . . 108, 112

Noncancellable period of lease . . . . . . . . . . . . . . . 108Lessee

Noncash investing and financial activities . . . . . . . . 406. accounting alternatives by private company . . . . . . . . 505

Noncompetition agreements . . . . . . . . . . . . . . . . 707. measurements by . . . . . . . . . . . . . . . . . . . . . . 108

Not-for-profit or nonpublic entityLessor, consolidation of real estate . . . . . . . . . . . . 505. accounting treatment for, U.S. GAAP . . . . . . . . . . . 504

Liabilities. FIN 48 for . . . . . . . . . . . . . . . . . . . . . . . . . . 306

. disclosure of tax . . . . . . . . . . . . . . . . . . . . . . . 306. securities of . . . . . . . . . . . . . . . . . . . . . . . . . 111

. lease . . . . . . . . . . . . . . . . . . . . . . . . . . . 108, 112

. off-balance sheet . . . . . . . . . . . . . . . . . . . . . . 105O

Limited liabilities companies. consolidation for . . . . . . . . . . . . . . . 504, 505, 506, 510 Off-balance-sheet transactions. elimination of special model for . . . . . . . . . . . . . . . 506 . for leases . . . . . . . . . . . . . . . . . . . . . . . . . . . 105. managing members of . . . . . . . . . . . . . . . . . . . 510 . recognition on balance sheet of . . . . . . . . . . . . . . 404

Limited partner, consolidation by . . . . . . . . . 506, 510, 511 Ordinary course of business. definition of . . . . . . . . . . . . . . . . . . . . . . . . 507, 510Limited partnerships. participating rights in . . . . . . . . . . . . . . . . . . . . 507. acquisitions or disposition of assets by . . . . . . . . . . 510

. collective bargaining agreements by . . . . . . . . . . . . 510P. condition for controlling financial interest in . . . . . . . . 508

. consolidation for . . . . . . . . . . . . 504, 505, 506, 510, 511Participating rights. dissolution (liquidation) of . . . . . . . . . . . . . . . . 507, 510. definition of . . . . . . . . . . . . . . . . . . . . . . . . . . 507. dividends or distributions of . . . . . . . . . . . . . . . . . 510. in limited partnership . . . . . . . . . . . . 506, 507, 510, 511. elimination of specialized model for . . . . . . . . . . 506, 510

Penalties, classification disclosures for . . . . . . . . . . 306. GAAP for . . . . . . . . . . . . . . . . . . . . . . . . . 506, 510. kick-out rights or participating rights in . . . 506, 507, 508, 510, Pension Benefit Guarantee Corporation (PBGC) . . . . . 806

511 . benefit guarantee maximum of . . . . . . . . . . . . . . . 810. noncontrolling rights in, effects of . . . . . . . . . . . . . 510 . 2014 Annual Management Report of . . . . . . . . . . . . 809. as VIEs . . . . . . . . . . . . . . . . . . . . . . . 506, 510, 511 . 2015 Annual Management Report of . . . . . . . . . . . . 810

Litigation, over disclosing to protect against . . . . . . . 404 Pension benefit payments, length of . . . . . . . . . . 805, 807

Pension plans . . . . . . . . . . . . . . . . . . . . . . . 801–813M. assets in . . . . . . . . . . . . . . . . . . . . . . . . . 811, 813. bankruptcy filings of underfunded . . . . . . . . . . . . . 806Management accountability for working capital. costs of maintaining . . . . . . . . . . . . . . . . 803, 807, 809management . . . . . . . . . . . . . . . . . . . . . . . . 406. disclosures for . . . . . . . . . . . . . . . . . . . . . . 404, 807

Management compensation, benchmark for . . . . . . . 407 . discount rates for . . . . . . . . . . . . . . . . . . . . 807, 808. employee enrollment in, declining . . . . . . . . . . . . . 809Management, going concern assessment by . . . . . . . 704. expected rates of return of, country comparison of . . . . 807

Market. factors contributing to decline of . . . . . . . . . . . . . . 803

. determination for inventory measurement of . . . . . . . 203. funding status of . . . . . . . . . 803, 805, 806, 808, 810, 812

. IRS definition of . . . . . . . . . . . . . . . . . . . . . . . 205. GAAP rules for . . . . . . . . . . . . . . . . . . . 803, 804, 812

Materiality threshold, determining . . . . . . . . . . . . . 404 . investment mix used by . . . . . . . . . . . . . . . . . . . 807. joint and several liability for . . . . . . . . . . . . . . . . . 806Moment of Truth: Report of the National Commission. largest, table of . . . . . . . . . . . . . . . . . . . . . . . 806on Fiscal Responsibility and Reform . . . . . . . . . . 306. local . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 810

Money market funds, consolidation for . . . . . 506, 509, 514 . multi-employer . . . . . . . . . . . . . . . . . . . . . . 806, 810. payment for shortfalls in . . . . . . . . . . . . . . . . . . . 810Mortality tables, MP-2014 . . . . . . . . . . . . . . . . . . 812. single-employer . . . . . . . . . . . . . . . . . . 805, 806, 810. state . . . . . . . . . . . . . . . . . . . . . . . . . . . 808, 810N. terminations of . . . . . . . . . . . . . . . . . . . . . . . . 809. trends in . . . . . . . . . . . . . . . . . . . . . . . . . . . 811Natural disasters. underreported liabilities of . . . . . . . . . . . . . . . . . 807. Code Sec. 1033 special involuntary conversion rule

for . . . . . . . . . . . . . . . . . . . . . . . . . . . . 607 Pension Protection Act of 2006 (PPA) . . . . . . . . . 803, 806. disclosure requirements for . . . . . . . . . . . . . . . . . 604

Physician practice (PP), consolidation for . . . . . . . . . 505. losses from terrorism and . . . . . . . . . . . . . . . . . . 605. potential risk of, vulnerability to . . . . . . . . . . . . . . . 604 Physician practice management entity (PPME) . . . . 505, 506

PHY


Primary beneficiary of a VIE . . . . . . . . . . . . . . . . . 506 Section 179 deductions, carryforwards of . . . . . . . . . 306. decision maker or service provider as . . . . . . . . . . . 511 Securities and Exchange Commission (SEC). definition of . . . . . . . . . . . . . . . . . . . . . . . . . . 510 . demands for business reporting by . . . . . . . . . . . 403, 404. fee arrangements for determining . . . . . . . . . . . . . 512

. initiatives to change lease accounting by . . . . . . . . . 105. related parties in determining . . . . . . . . . . . . . . . . 513

. new mortality tables requirements of . . . . . . . . . . . . 812Private Company Council (PCC) . . . . . . . . . . . . . . 707 . 21 st Century Disclosure Project of . . . . . . . . . . . . . 404

Projected benefit obligation (PBO) of pension plans . . 807 Securities, categories of debt or equity . . . . . . . . . . 504

Pronouncements issued 2003 to 2016, table of Service contract, cloud computing arrangement as . . . 705selected . . . . . . . . . . . . . . . . . . . . . . . . . . . 404

Severe impact, ASC 275 definition of . . . . . . . . . . . . 604Protective rights

SFAS 167, Amendments to FASB Interpretation No.. definition of . . . . . . . . . . . . . . . . . . . . . . . . . . 50746(R) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 506. in limited partnership . . . . . . . . . . . . . . . . . . 505, 510

Society of Actuaries (SOA), MP-2014 mortality tablesPublic Company Accounting Oversight Boardof . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 812(PCAOB) created under Sarbanes-Oxley Act of . . 401, 403

Software, internal-use . . . . . . . . . . . . . . . . . . . . 705Public entity. accounting treatment for, U.S. GAAP . . . . . . . . . . . 504 SSARS 21, going concern assessment under . . . . . . . 704. leases of . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

Standard & Poor’s, Measures of Corporate Earningsby . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407

QStatement of cash flows . . . . . . . . . . . . . . . . . 404, 405. use in calculating free cash flow of . . . . . . . . . . . . . 406Quantitative easing, effects of . . . . . . . . . . . . . . . . 807. use in rewarding management of . . . . . . . . . . . . . . 407

R Statement of changes in net assets available tocommon shareholders . . . . . . . . . . . . . . . . . . 404

Rabbi trusts, consolidation for . . . . . . . . . . 504, 505, 506Statement of comprehensive income . . . . . . . . . . . 405

Ratios used in financial performance measurement . 406, 407Statement of financial position . . . . . . . . . . 405, 515, 808

Raw materials inventory . . . . . . . . . . . . . . . . . . . 205Statement of income . . . . . . . . . . 405, 407, 608, 706, 812

Realized deferred tax liability or asset . . . . . . . . . . . 303Statement of operations . . . . . . . . . . . . . . 604, 606, 608

REL ConsultingStates. Improving Shareholder Value Through Total Working. apportionment of income by . . . . . . . . . . . . . . . . 112Capital by . . . . . . . . . . . . . . . . . . . . . . . . 407

. 2015 U.S. Working Capital Survey by . . . . . . . . . 406, 407 . pension plans of . . . . . . . . . . . . . . . . . . . . . 808, 810

Related parties for VIE . . . . . . . . . . . . . . . . . . . . 506 Straight-line accounting method for rent expense . . . . 109. in determining primary beneficiary . . . . . . . . . . . . . 513

Substantial doubt about ability to continue as going. indirect interests held by . . . . . . . . . . . . . . . . . . 511

concern . . . . . . . . . . . . . . . . . . . . . . . . . . . 704Replacement cost for market . . . . . . . . . . . . . . . . 203

TResearch and development arrangements . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . 504, 505, 506, 508

Tax Foundation, Corporate Income Tax Rates AroundRetailers the World, 2014, The by . . . . . . . . . . . . . . . . . . 306. impact of lease accounting changes for . . . . . . . . . . 112

Tax planning, effects of new lease standard on . . . . . . 112. operating lease obligations of . . . . . . . . . . . . . . . . 105

Tax years, open . . . . . . . . . . . . . . . . . . . . . . . . 306Retirees, life expectancy of . . . . . . . . . . . . 805, 807, 812

Taxable income, tax planning strategies for . . . . . . 304, 306Retirement assets, non-governmental plan . . . . . . . . 811

Temporary differences between book and tax basis . . . 303Retirement income shortfall . . . . . . . . . . . . . . . . . 811. creation of . . . . . . . . . . . . . . . . . . . . . . . . . . 305

Revenue recognition standard . . . . . . . . . . . . . . . 404. disclosure of . . . . . . . . . . . . . . . . . . . . . . . . . 306

Review engagement, going concern assessment in . . . 704 . during NOL carryforward period . . . . . . . . . . . . . . 304. property insurance proceeds creating . . . . . . . . . . . 608Right-of-use assets . . . . . . . . . . . . . . . . . . . . 108, 112. reversal of . . . . . . . . . . . . . . . . . . . . . . . . 304, 306

Right-of-use model for lease accounting . . . . . . . . . 107Terrorism

Risk factors, disclosures of . . . . . . . . . . . . . . . . . 404. gains and losses related to . . . . . . . . . . . . . . . . . 603. losses from acts of God and . . . . . . . . . . . . . . . . 605

S. U.S. GAAP for . . . . . . . . . . . . . . . . . . . . . . 601–608

S&P 500 . . . . . . . . . . . . . . . . . . . . . . . . . . . 407, 813 Terrorist attack. Boston 2013 . . . . . . . . . . . . . . . . . . . . . . . 603, 606S&P 1500, pension plan funding for . . . . . . . . . . 803, 805. insurance recoveries from . . . . . . . . . . . . . . . . . 606

SAB Top 5.BB-Inventory Valuation Allowance . . . . . . 205 . New York 2001 . . . . . . . . . . . . . . . . . . . . . . . 603. potential risk of, vulnerability to . . . . . . . . . . . . . . . 604Sarbanes-Oxley Act of 2002

. accounting pronouncements responding to . . . . . . . . 404 TPA 5250-15, Application of Certain FASB

. PCAOB created under . . . . . . . . . . . . . . . . . 401, 403 Interpretation No. 48 (Codified in FASV ASC 740-10)

. response in lease accounting to . . . . . . . . . . . . 105, 106 Disclosure Requirements to Nonpublic Entities That DoSEC Staff Accounting Bulletins (SABs) . . . . . . . . . . 404 Not Have Uncertain Tax Positions . . . . . . . . . . . . 306

PRI


TPA Section 3700, Pension Obligations .01 Effect of Variable interest entity (VIE)—continuedNew Mortality Tables on Nongovernmental Employee . variable interest in . . . . . . . . . . . . . . . . . . . . 506, 511Benefit Plans (EBPs) and Nongovernmental Entities That Variable interest entity model . . . . . . . . . . . . . . . . 508Sponsor EBPs . . . . . . . . . . . . . . . . . . . . . . . 812 . evaluation for consolidation using . . . . . . . . . . . . . 510

. treatment of related parties in . . . . . . . . . . . . . . . . 513Trade receivables . . . . . . . . . . . . . . . . . . . . . . . 406

Voting interest entity model . . . . . . . . . . . . . . . 506, 508U . evaluation for consolidation using . . . . . . . . . . . . . 510

. fees paid to decision makers or service providers of . 506, 511Uncertain tax positions (UTPs) . . . . . . . . . . . . . . . 306

Variable lease payments . . . . . . . . . . . . . . . . . . . 108Union employees, pension plans for . . . . . . . . . . . . 806

Voting shares, tiers of ownership of . . . . . . . . . . . . 504Unions, retirement benefit negotiations by . . . 803, 806, 810

WUnrecognized tax benefit liabilities for financialstatements . . . . . . . . . . . . . . . . . . . . . . . . . 306

War, possible effects of . . . . . . . . . . . . . . . . . . . 604Unrecognized tax benefits, disclosures for . . . . . . . . 306

With cause, definition of . . . . . . . . . . . . . . . . . . . 507

V Without cause, definition of . . . . . . . . . . . . . . . . . 507

Work product protection . . . . . . . . . . . . . . . . . . . 306Valuation account . . . . . . . . . . . . . . . . . . . . . 304, 306

Working capitalValuation allowance to reduce deferred tax asset . . 304, 306

. analysts’ focus on . . . . . . . . . . . . . . . . . . . . . . 406Valuation models, free cash flow in . . . . . . . . . . . . . 406 . ratios used to analyze . . . . . . . . . . . . . . . . . . 406, 407

Variable interest entity (VIE) . . . . . . . . . . . . . . . . . 112 Working capital management . . . . . . . . . . . . . . 406, 407. consolidation rules for . . . . . . . . . . . . . . . 504, 505, 506 Workpapers, tax accrual . . . . . . . . . . . . . . . . . . . 306. controlling financial interest of . . . . . . . . . . . . . . . 508

WorldCom fraud . . . . . . . . . . . . . . . . . . . . . . 401, 403. decision making for . . . . . . . . . . . . . . . . . . . 505, 507. kick-out rights for . . . . . . . . . . . . . . . . . . . . . . 507 Worldwide average corporate tax rate . . . . . . . . . . . 306. limited partnership as . . . . . . . . . . . . . . . 506, 510, 511. primary beneficiary of . . . . . . . . . . . . 506, 510, 511, 512 X. protective rights for . . . . . . . . . . . . . . . . . . . . . 507. risk of loss in . . . . . . . . . . . . . . . . . . . . . . . . . 511 XBRL tagging for financial statement disclosures . . . . 404

XBR

197

¶10,200 Final Exam InstructionsCompleting your Final Exam online at CCHGroup.com/PrintCPE is the fastest wayto earn CPE Credit with immediate results and no Express Grading Fee.

This Final Exam is divided into three Modules. There is a grading fee for each FinalExam submission.

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¶10,200



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¶10,200



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199

¶10,301 Final Exam Questions: Module 1

1. One key change under the new lease standard is:

a. A very small portion of operating leases, but not capital leases, will be broughtonto the balance sheet.

b. Capital leases, but not operating leases, will be brought onto the balance sheet.

c. No leases will be capitalized.

d. Most existing operating leases will be brought onto the balance sheet.

2. Under the new lease standard, which of the following is true as it relates to thelessee?

a. An asset is recognized representing the sum of the lease payments over thelease term.

b. An asset is not recognized.

c. An asset is recognized representing the lessee’s right to use the leased assetfor the lease term.

d. An asset is recognized only if four criteria are met.

3. Which of the following is not considered part of lease payments under the new leasestandard?

a. Fixed payments

b. Amortization on the underlying leased asset

c. Exercise price of a purchase option

d. Payments for penalties for terminating the lease

4. How will a lessee account for initial direct costs incurred in connection with a lease,under the new lease standard?

a. Initial direct costs are included in the lease asset that is recorded at thecommencement date.

b. Initial direct costs are not part of the lease asset.

c. Initial direct costs are expensed as period costs.

d. The new lease standard is silent as to how to account for initial direct costs.

5. What happens to existing leases on the date of adoption of the new lease standard?

a. Existing operating leases are grandfathered but capital leases are not.

b. Existing capital leases are grandfathered but operating leases are not.

c. The new standard does not grandfather any existing leases.

d. Existing leases are phased into the new standard over a four-year period.

6. Under the proposed lease standard, which of the following is true?

a. Lease terms are likely to shorten to decrease the amount of the leaseobligation.

b. Lease terms are likely to get longer to reduce the amount of the leaseobligation.

c. Lease terms are likely to shorten to increase the amount of the lease assetrecorded.

d. Lease terms are likely to get longer to reduce the amount of the lease assetrecorded.

¶10,301


7. The new lease standard will likely result in which of the following occurring forexisting operating leases?

a. Total lease expense for tax purposes will be greater than total GAAP expense.b. Total GAAP expense will be greater than lease expense for tax purposes.c. GAAP and tax expense will be identical.d. There will be no change in the total expense for GAAP or tax purposes from

current practice.8. Under the new lease standard :

a. Deferred tax assets will likely be created.b. Deferred tax assets will likely be reduced.c. Deferred tax liabilities will likely be created.d. Deferred tax liabilities will likely be reduced.

9. One potential impact from the new lease standard will be that the debt-equity ratiowill be :

a. Higherb. Lowerc. The samed. Either higher or lower depending on several factors

10. One potential impact from the proposed lease standard for Type A leases would bethat EBITDA would have a/an:

a. Favorable impact because interest would decrease while rental expense wouldincrease

b. Unfavorable impact because depreciation would increase while rental expensewould decrease

c. Favorable impact because interest and amortization expense would increasewhile rental expense would decrease

d. Unfavorable impact because interest, depreciation and rental expense would allincrease

11. With respect to FIFO inventory, ASU 2015-11 replaces the concept of “market�with which of the following?

a. Replacement costb. Fair valuec. Normal profitd. Net realizable value

12. Company K uses the LIFO inventory valuation method and has adopted theamendments of ASU 2015-11. At the end of the year, the Company should measure itsinventory based on which of the following?

a. Net realizable valueb. Lower of cost and net realizable valuec. Lower of cost or marketd. Cost

¶10,301

201FINAL EXAM QUESTIONS: MODULE 1

13. Company L wrote down its inventory to lower of cost and net realizable value in theprevious year, and in the current year, it appears that there is a recovery of the write-down. Based on this fact pattern, which of the following statements is correct withrespect to U.S. GAAP?

a. The company is permitted to reverse the previous year’s write-down.b. The company cannot reverse the previous year’s write-down under U.S. GAAP.c. The company is permitted to reverse the previous year’s write-down above

original cost.d. The company cannot reverse the previous year’s write-down under U.S. GAAP

unless it adopts the amendments of ASU 2015-11.14. A company is performing a lower of cost and net realizable value test on its year-end inventory. Which of the following would not be an appropriate approach to performthe test if the company’s inventory has about 1,000 individual items and two majorcategories of products?

a. Directly on each of the 1,000 individual itemsb. To the total inventory in each of the two major categoriesc. To the total inventoryd. Only on five percent of the total inventory

15. If Company Q is implementing the amendments prescribed by ASU 2015-11, thenthe company should apply the changes using which of the following transition methods?

a. Retroactivelyb. Retrospectivelyc. Prospectivelyd. Modified Retroactive

16. A manufacturer that uses raw materials in its manufacturing process must applythe amendments of the ASU to which of the following?

a. Segments or inventory in totalb. Raw materialsc. Work in processd. Total replacement cost

17. The amendments of ASU 2015-11 amended which of the following ASC topics?a. ASC 315b. ASC 840c. ASC 250d. ASC 330

18. Which one of the following Code sections permits, but does not require, an entityto use lower of cost or market for its inventory valuation?

a. Code Sec. 470b. Code Sec. 471c. Code Sec. 845d. Code Sec. 846

¶10,301


19. The amendments of ASU 2015-11 are effective for public business entities for fiscalyears beginning after which of the following?

a. December 15, 2016b. December 15, 2017c. December 31, 2016d. December 31, 2017

20. The amendments of ASU 2015-11 are effective for nonpublic business entities forfiscal years beginning after which of the following?


21. Which of the following identifies the difference between the book and tax basis ofan asset or liability that will result in taxable or deductible amounts in future years whenthe reported amount is recovered or settled?

a. Temporary differenceb. Permanent differencec. Tax differentiald. Non-GAAP adjustment

22. When deferred tax accounts are adjusted for the effect of a change in tax laws orrates, the effect should be included in which of the following for the period that includesthe enactment date?

a. Tax expenseb. Extraordinary itemsc. Stockholders’ equityd. Cumulative translation adjustment

23. ASC 740 requires a company to recognize which of the following against a deferredincome tax asset if, based on the weight of available evidence, it is more likely than notthat some portion or the entire deferred tax asset will not be realized?

a. Reserve accountb. Contra assetc. Valuation accountd. Impairment

24. At December 31, 20X4, Company Y has a deferred tax asset due to an unused NOLcarryforward. Y has had cumulative losses in years 20X2, 20X3, and 20X4. There are nodeferred income tax liabilities at December 31, 20X4. In assessing whether the companywill have sufficient future taxable income to absorb the deferred tax asset, how shouldthe three years of cumulative losses be considered?

a. The losses should be considered strong negative evidence in making theassessment.

b. The losses should be disregarded in making the assessment.c. The losses are only a small factor to be considered in making the assessment.d. There must be at least five years of cumulative losses to be considered in

making the assessment.

¶10,301

203FINAL EXAM QUESTIONS: MODULE 1

25. In estimating future taxable income that will absorb deferred tax assets, suchestimated future taxable income .

a. Should exclude any taxable income from reversal of existing deferred incometax liabilities

b. Should include all estimated future taxable income that will be generatedduring the carryforward period

c. Should be limited to income estimated over the first five years in the carryfor-ward period

d. Should include taxable income from reversal of existing deferred income taxassets

26. Company X is a nonpublic entity that has no uncertain tax positions liability. Whichof the following is correct?

a. X must disclose the number of tax years open for tax examination.b. X must include an abbreviated disclosure of the number of tax years open for

examination.c. The exclusion of the disclosure only applies if X is SEC registered and not a

nonpublic entity.d. X is not required to disclose the number of tax years open for examination.

27. When determining whether a valuation account is required, which of the followingidentifies positive evidence that would suggest the valuation account is not required?

a. Excess of appreciated asset value over the tax basis of the entity’s net assetsb. Cumulative losses in recent yearsc. Unsettled circumstances that can adversely affect future operationsd. Carryback period so brief that would limit realization of tax benefits

28. Each of the following is an example of a tax-planning strategy that can be used toutilize an NOL, except:

a. Changing the character of items from capital gain to ordinary incomeb. Selling investments including available-for-sale securities to accelerate taxable

incomec. Switching from tax-exempt to taxable investmentsd. Changing tax status in order to accelerate taxable income

29. Which of the following FASB Interpretations, prior to codification within ASC 740,provided guidance with respect to uncertain tax benefit liabilities?

a. FIN 45b. FIN 48c. FIN 19d. FIN 34

¶10,301


30. Which of the following corporations would be required to file Schedule UTP withintheir corporate tax return based on the guidance prescribed by IRS Announcement2010-75?

a. The corporation has assets of approximately $5 million.b. A related party to the corporation issued audited financial statements reporting

a portion of the corporation’s operations for a portion of its tax year.c. The corporation has approximately $2 million in deferred tax assets.d. The corporation has assets of less than $7 million.

31. According to the IRS Attention study, which of the following statements is correctwith respect to increased IRS attention of corporate disclosures subsequent to theimplementation of FIN 48?

a. There is increased usage of computer algorithms to pull information fromEDGAR.

b. The average downloaded 10-K is more than three years old.c. The IRS attention is strongly driven by firm size, foreign profitability, and

NOLs.d. Cash effective tax rate is the single primary financial statement measure used

by the IRS.32. Which of the following financial statement measures appeared to be used morefrequently based on results of the IRS Attention study?

a. Income from continuing operationsb. Return on stockholders’ equityc. Marginal corporate income tax rated. Unrecognized tax benefit liabilities

33. Which of the following ASUs issued by the FASB prescribed that deferred incometax assets and liabilities should be presented as noncurrent on an entity’s balance sheet?

a. ASU 2015-17b. ASU 2016-02c. ASU 2015-11d. ASU 2016-01

34. Based on the Tax Foundation’s study entitled Corporate Income Tax Rates aroundthe World, 2014, which of the following countries has a 0 percent corporate income taxrate?

a. Spainb. Bahamasc. Japand. Ireland

35. Which of the following can be carried forward five years for that portion thatexceeds 10 percent of taxable income?

a. Capital lossb. Section 179 deductionc. NOLsd. Charitable contributions

¶10,301

205Final Exam Questions: Module 2

¶10,302 FINAL EXAM QUESTIONS: MODULE 2

36. One of the 12 recommended principles for a comprehensive business reportingmodel is that the company must be viewed from the perspective of .

a. All investors in the company’s equityb. All third parties with a range of perspectives consideredc. The current investor in the company’s common equityd. The financial analyst

37. One of the 12 recommended principles is that the cash flow statement providesessential information and should .

a. Be prepared using the indirect methodb. Be prepared using the direct methodc. Add a fourth category in addition to operating, investing, and financing

activitiesd. Reconcile to working capital instead of cash

38. One of the 12 recommended principles is that all changes in net assets must berecorded in the:

a. Cash flow statementb. Statement of changes in stockholders’ equityc. Income statementd. Statement of changes in net assets available to common shareholders

39. IBM’s investors complain about the fact that IBM’s disclosures keep growing fromyear to year. Which of the following might be a prime reason why IBM over-discloses intheir notes to financial statements?

a. To protect against litigationb. To save time in removing disclosures from period to periodc. To avoid challenges from over-reactive third parties who seek specific

informationd. Because those in charge of governance may be ignorant of accounting and

disclosure issues40. Implications of a drastic change in the format of financial statements would includeall of the following except:

a. Tax return M-1 reconciliation would differ.b. Contract formulas for bonuses would have to be rewritten.c. The cost would be significant.d. The use of the term cash equivalents would remain intact.

41. ASC 230, Statement of Cash Flows, requires that non-cash investing and financialactivities be disclosed but excluded from the statement of cash flows. Examples of thesenon-cash activities include all but which of the following?

a. Purchase of equipment by issuance of a noteb. Establishment of capital leasesc. Conversion of debt to equityd. Payment of stock dividends

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42. Free cash flow is the amount of cash flow that is free after accounting for:a. Fixed commitments such as capital expenditures and preferred stock

dividendsb. Unrealized gains and losses on securitiesc. Variable items such as commissions and other variable costsd. Other income or expense

43. Which of the following would be the logical flow of particular elements in financialstatements?

a. Working capital flows to cash.b. Core earnings flow to working capital.c. Cash flows to free cash flow.d. Inventories flow to receivables.

44. Four key ratios provide a thorough analysis of working capital. These ratiosinclude all of the following except:

a. Days payables outstandingb. Days sales in accounts receivablec. Days in cash flowd. Days supply in inventory

45. How is Days Sales Outstanding (DSO) calculated?

46. Assume the following:Days sales outstanding (DSO) is 45 daysBest possible DSO is 30 daysCredit terms are 20 days Which is the average days delinquent (ADD)?

a. 10 daysb. 15 daysc. Zerod. 25 days

47. Which of the following is true?a. DSO and ADD always move in the same direction.b. DSO and ADD always move in different directions.c. DSO and ADD can move in different directions but only as a result of

collections efficiency.d. None of the above

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48. Symptoms of inefficiently managed working capital include all of the followingexcept:

a. Bad debts are increasing.b. Customer service levels are higher than normal.c. Interest payments to suppliers are increasing.d. Receivables are growing disproportionately to sales.

49. One of the practices that companies can implement to create a long-term workingcapital management programs:

a. Link cash flow performance and working capital management to compensationstructure.

b. Individualize customer and supplier payment termsc. Automate and eliminate low-volume, high-margin transactions to free up

resources.d. None of the above

50. In the computation of the S&P’s Core Earnings, items excluded consist of all of thefollowing except:

a. Gains/losses from asset salesb. Goodwill impairment chargesc. Merger/acquisition related expensesd. Pension costs

51. If a physician practice management entity (PPME) has a controlling financialinterest in a physician practice, how should the PPME account for the physicianpractice?

a. Consolidate itb. Record it at equity methodc. Record it at costd. Make no entry

52. In accordance with ASC Subtopic 810-20 and the rules in effect prior to thechanges made by ASU 2015-02, there is a presumption that a general partner alimited partnership regardless of the extent of the general partners’ ownership interestin the limited partnership.

a. Managesb. Controlsc. Has significant influence ind. Materially participates in

53. A key aspect of a variable interest entity (VIE) is that it:a. Is not self-supportiveb. Can finance its activities without additional financial supportc. Is not required to be consolidatedd. Controls a subsidiary

54. An example of where combined financial statements may be useful is:a. A group of unconsolidated entitiesb. Tax planning strategiesc. When one entity wishes to augment its balance sheetd. Where there is a group of unrelated parties that wish to join forces

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55. If combined financial statements are presented, combining is treated essentially inthe same manner as a consolidation with:

a. No intercompany transactions eliminated

b. All intercompany transactions eliminated

c. Selected intercompany transactions eliminated

d. Only equity accounts consolidated with eliminations made

56. In accordance with ASU 2015-02, under the voting interest entity model for limitedpartnerships, a limited partner has a controlling financial interest in a limited partner-ship if it has more than 50 percent of the limited partnership’s .

a. Subscription rights

b. Participation rights

c. Kick-out rights

d. Controlling rights

57. Which of the following does ASU 2015-02 change with respect to a general partnerand a limited partnership?

a. Eliminates the presumption that a general partner should consolidate a limitedpartnership

b. Now requires that a general partner consolidate a limited partnership in allinstances

c. Now precludes a general partner from consolidating a limited partnership in allinstances

d. Adds a rule that a general partner consolidate a limited partnership if thegeneral partner holds more than 80 percent of the voting interest in the limitedpartnership

58. Company X is a non-controlling limited partner in a limited partnership. X hasnoncontrolling rights that allow it to block partnership actions. Such rights are called

:

a. Participation rights

b. Kick-out rights

c. Blocking rights

d. Protective rights

59. Company J has several rights in an investee. J wants to determine whether they areNon-controlling. Which of the following rights of J is considered non-controlling?

a. Selection of board members

b. Name of investee

c. Selection of senior management

d. Right to sell the entity

60. One key change made by ASU 2015-02 is that some fees paid to a decision maker:

a. Are excluded from the evaluation of whether the decision maker is the primarybeneficiary of a VIE

b. Are included in the test as to whether an entity is a VIE

c. Are used in the computation of whether debt is nonrecourse under the VIErules

d. Are considered equity for purposes of determining if there is a controllingfinancial interest

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61. The amendments within ASU 2015-02 are effective for public business entities forfiscal years and for interim periods within those fiscal years beginning after what date?


62. The amendments within ASU 2015-02 are effective for nonpublic business entitiesfor fiscal years beginning after what date?


63. The amendments within ASU 2015-02 may be applied by an entity using which ofthe following methods?

a. Modified retrospectiveb. Prospectivec. Modified prospectived. Prospective with an adjustment to equity

64. Which of the following ASUs endorsed by the FASB and issued by the PrivateCompany Council provided a private company exemption from consolidation under FIN46R rules?


65. Which of the following conditions was eliminated as a result of ASU 2015-02 forevaluating whether a fee paid to a decision maker or a service provider represented avariable interest?

a. Substantially all of the fees are at or above the same level of seniority as otheroperating liabilities of the entity that arise in the normal course of the entity’sactivities, such as trade payables.

b. The fees are compensation for services provided and are commensurate withthe level of effort required to provide those services.

c. The decision maker or service provider does not hold other interests in theVIE that individually, or in the aggregate, would absorb more than an insignifi-cant amount of eh VIE’s expected losses or receive more than an insignificantamount of the VIE’s expected residual returns.

d. The service arrangement includes only terms, conditions, or amounts that arecustomarily present in arrangements for similar services negotiated at arm’slength.

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66. Which of the following types of rights is a unilateral right to exit from thepartnership in whole or in part that does not require dissolution or liquidation of theentire limited partnership would not be deemed a kick-out right?

a. Protective rightsb. Kick-out rightsc. Participating rightsd. Withdrawal rights

67. Each of the following identifies an exception to the more than 50 percent owner-ship test consolidation guidance with ASC 810, except:

a. Entities controlled by a contractb. Limited partner that controls a general partnerc. Miscellaneous transactions involving research and development arrangementsd. VIEs

68. The amendments in ASU 2015-02 did not have an effect on which of the following?a. Physician Practice Management Entitiesb. Variable interest entity modelc. General partners that control a limited partnershipd. Evaluating fees paid to a decision maker

69. With respect to certain investment funds, ASU 2015-02 rescinded the indefinitedeferral included within which of the following ASUs?


70. If a decision maker or service provider (reporting entity) concludes that feesreceived represent a variable interest in a VIE, the reporting entity should evaluatewhich of the following?

a. Whether it is the primary beneficiary of the VIEb. Whether the fees received are at market termsc. Whether the fees received were appropriately approved for paymentd. Whether the fees relate to guarantees of assets or liabilities

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¶10,303 FINAL EXAM QUESTIONS: MODULE 3

71. The disclosure requirements of ASC 275 require that entities make disclosures intheir financial statements about risks and uncertainties arising from which of thefollowing?

a. Certain significant estimatesb. Proposed changes in governmental regulationsc. Deficiencies in internal control structured. Possible effects of acts of God, war, or sudden catastrophe

72. As a result of the issuance of ASU 2015-01, the FASB effectively eliminated therecognition of which of the following financial statement treatments?

a. Loss contingenciesb. Extraordinary and unusualc. Gain contingenciesd. Material dispositions

73. Which of the following Code sections provides a special rule to deal with disasterunder the involuntary conversion rules?

a. Code Sec. 1033b. Code Sec. 1034c. Code Sec. 1065d. Code Sec. 1099

74. A company maintains insurance to cover business interruption losses and thecompany’s store is damaged from a terrorist attack. If the company files a claim with theprovider but is uncertain of the final settlement, the company should do which of thefollowing?

a. Recognize a gain when those contingencies are resolved by settlement of theclaim

b. Recognize a gain for the amount the company anticipates receivingc. Record a receivable for the total proceeds anticipated to be received from the

insurance providerd. Disclose the uncertainty of the settlement if the proceeds are expected to

exceed $500,000

75. ASC 605 requires that any insurance recoveries should be:a. Recorded as other incomeb. Netted against the related loss on the same income statement itemc. Recorded as an extraordinary gaind. Classified as an adjustment to equity

76. In accordance with the FASB’s ASU 2014-15 related to going concern, manage-ment’s evaluation of going concern runs for what period of time?

a. One yearb. Six monthsc. A reasonable period of time that is no quantifiedd. Eighteen months

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77. Company X has signed a contract and obtains access to software in a hostingarrangement. In accordance with ASU 2015-05, which of the following is one of thecriteria that must be met in order for X to treat it as internal-use software?

a. X is not permitted to run the software on its own hardware.b. X has the contractual right to take possession of the software without signifi-

cant penalty.c. X is permitted to take possession of the software by paying a significant

penalty.d. X is not permitted to have another party unrelated to the vendor to host the

software.

78. Which of the following is generally excluded from debt issuance costs?a. Legal feesb. Appraisal costsc. Title insuranced. Internal general and administrative costs

79. Company X is a private company that is acquiring the net assets of Company Y. If Xelects to use the accounting alternative under ASU 2014-18, which of the following istrue?

a. X should allocate a portion of acquisition cost to all customer-related intangibleassets.

b. X should recognize all intangible assets separately from goodwill.c. X should no longer recognize customer-related intangible assets from good-

will, unless those assets are capable of being sold or licensed independently.d. X should not recognize a separate value for goodwill.

80. Company W is purchasing the net assets of Company Z. Company W has electedthe accounting alternative related to identifiable intangibles in ASU 2014-18. Which ofthe following should no longer be recognized separately from goodwill?

a. Inventoryb. Fixed assetsc. Noncompetition agreementd. Liabilities

81. Which of the following identifies a characteristic of a multi-employer pension plan?a. Many employers are part of one, identical collective bargaining agreement.b. Assets contributed by one particular employer must be used for that em-

ployer’s employees only.c. Employers are jointly and severely liability for the plan obligations.d. There is no withdrawal or exit fee.

82. Which of the following statements can be discerned from the recomputed analysisperformed by Credit Suisse of the funded status of pension plans?

a. The funded status shortfall of $(101) billion is distorted and should be about$(428) billion.

b. The funded status shortfall of $(101) billion fairly represents the funded statusof pension plans.

c. The funded status shortfall of $(101) billion really should be a surplus of about$500 billion.

d. The funded status is understated because of the poor stock marketperformance.

¶10,303


83. Hostess was able to achieve which of the following as a result of filing for Chapter11 protection?

a. It paid a reduced pension withdrawal liability.b. It shifted the burden of its single employer plans to the unions.c. It terminated all of its single and multi-employer plans.d. It shifted the burden of its multi-employer plans to the IRS.

84. Which of the following as the average rate of earnings anticipated on the fundsinvested or to be invested?

a. Actual returnb. Expected rate of returnc. Discounted rate of returnd. Projected rate of return

85. Which of the following statements with respect to the expected rates of returnused by U. S. pension plans compared to those rates used by other major countries inmeasuring their pension liabilities is correct?

a. The U.S. rates are significantly higher than those used in other countries.b. The U.S. rates are the same as those used in other countries.c. The U.S. rates are slightly lower than those used in other countries.d. The U.S. rates are significantly lower than those used in other countries.

86. Which of the following identifies a change to public pension plans based on therelease of GASB Statement 68?

a. Use of a higher expected rate of returnb. Reporting of the funded status of the plans on the statement of financial

positionc. Use of a higher discount rated. Use of a higher compensation growth rate

87. Which of the following organizations is in financial distress and may have to bebailed out by Congress because of its $88 billion in assets and exposure of $377 billionfor potential claims?

a. Congressional Budget Officeb. Pension Fund Society of Americac. Pension Benefit Guaranty Corporationd. Social Security Administration

88. Based on several recent studies, the unfunded liabilities for 2015 of total U.S.Corporate and Public pension plans is estimated to be what amount on the high end?

a. $8.2 trillionb. $5.9 trillionc. $13.5 trilliond. $9.6 trillion

89. Based on the 2016 William Mercer study of single employer pension plans, thepercentage of funded status for 2015 was which of the following?

a. 82 percentb. 79 percentc. 65 percentd. 91 percent

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90. Which of the following color zones requires that a plan must emerge from criticalcondition within 10 years and allows the plan to cut previously earned adjustablebenefits?

a. Yellow

b. Red

c. Brown

d. Orange

91. Which of the following color zones requires a funding improvement plan alongwith a one-fifth improvement in funded status within 15 years?

a. Red

b. Yellow

c. Orange

d. Blue

92. Based on Credit Suisse’s recomputed analysis of the funded status of a sample of1,354 pension plans, what percentage of plans were in the critical zone?

a. 38 percent

b. 56 percent

c. 88 percent

d. 91 percent

93. Based on the 2014 Corporate Pension Funding Study from Milliman, which of thefollowing identifies the expected rate of return used by pension plans for the last severalyears?

a. 8.0 percent

b. 7.5 percent

c. 4.5 percent

d. 6.0 percent

94. GASB Statement 68 requires the immediate recognition of which of the followingon the pension liability?

a. Annual service cost

b. Changes in fair value of plan assets

c. Tax-exempt bond percent returns

d. Net investment cost

95. Which of the following types of retirement plans currently account for the highestpercentage of plan assets for non-governmental employees based on the U.S. Retire-ment Market analysis by the Investment Research Institute?

a. 401(k) defined contribution plans

b. IRAs

c. Defined benefit plans

d. ROTH IRAs

¶10,303

215

¶10,400 Answer Sheets¶10,401 Top Accounting Issues for 2017 CPE Course:MODULE 1

(10014576-0005)

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Module 1: Answer Sheet

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Please answer the questions by indicating the appropriate letter next to the correspond-ing number.

1. 10. 19. 28.

2. 11. 20. 29.

3. 12. 21. 30.

4. 13. 22. 31.

5. 14. 23. 32.

6. 15. 24. 33.

7. 16. 25. 34.

8. 17. 26. 35.

9. 18. 27.

Please complete the Evaluation Form (located after the Module 3 Answer Sheet)and return it with this Final Exam Answer Sheet to Wolters Kluwer at theaddress on the previous page. Thank you.

217MODULE 2 - ANSWER SHEET

¶10,402 Top Accounting Issues for 2017 CPE Course:MODULE 2

(10014577-0005)



NAME

COMPANY NAME

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Module 2: Answer Sheet(10014577-0005)


36. 45. 54. 63.

37. 46. 55. 64.

38. 47. 56. 65.

39. 48. 57. 66.

40. 49. 58. 67.

41. 50. 59. 68.

42. 51. 60. 69.

43. 52. 61. 70.

44. 53. 62.


219MODULE 3 - ANSWER SHEET

¶10,403 Top Accounting Issues for 2017 CPE Course:MODULE 3

(10014578-0005)



NAME

COMPANY NAME

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E-MAIL ADDRESS

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METHOD OF PAYMENT:



Card No. Exp. Date

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Module 3: Answer Sheet(10014578-0005)


71. 76. 81. 86. 91.

72. 77. 82. 87. 92.

73. 78. 83. 88. 93.

74. 79. 84. 89. 94.

75. 80. 85. 90. 95.


221

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